How Much Change When BOJ Eventually Tweaks? Part 1

Deputy Governor Says Rise In Interest Rates Will Be Very Gradual

Source: https://www.mof.go.jp/english/jgbs/reference/gbb/index.htm and http://www.stat-search.boj.or.jp/index_en.html

(I’ll be speaking at Harvard at 12-1 pm Eastern Time on March 18th. To attend in person, see location and other information at https://us-japan.wcfia.harvard.edu/katz-3-18-2024. Advance registration is not necessary. Just show up. To view it online, advanced registration is necessary. Click https://harvard.zoom.us/meeting/register/tJwvfu2srTgsGNCrmW4QOzVxnO3Kac7esLJ9#/registration.)

Once again, the financial markets are betting that there’s a 53% chance the Bank of Japan (BOJ) will tighten monetary policy after its March 18-19^th meeting and 80% no later than April 26^th. Traders were just as sure right before a few of the most recent BOJ meetings and have lost a considerable amount of money by being wrong. One day, they’ll be right. Unfortunately, the Bank has been giving out mixed signals, some of them suggesting that it might move that quickly. (I’ll discuss one of them below regarding wage trends.) Then, at a February 29 press conference, Governor Kazuo Ueda seemed to be trying to tamp down anticipation of such an early move, saying, “As to the question of whether we are in a situation where we can foresee the inflation target as attained sustainably and stably, in my view, we are not there yet.”

The Takeaways From Uchida’s Speech

I’ll come back to the issue of timing below, but first, let’s ask: would a policy tweak mean a substantial rise in interest rates over the coming year or a slow, incremental change?

            The outlook for interest rates depends not only on BOJ policy but also on supply-demand conditions in financial markets. For years, Japan’s economy has been marked by an excess of private savings relative to the private need to borrow. Incoming corporate cash flow, for example, exceeds business investment by more than 6% of GDP per year. Moreover, the volume of net corporate savings keeps growing (see chart below). So, companies don’t need to borrow from either banks or the bond market. With demand so lame, even if the BOJ were to let long-term interest rates float freely, market-determined interest rates would not suddenly spike.

Source: https://www.mof.go.jp/english/pri/reference/ssc/historical/all.xls

            As for the BOJ’s intentions, I was told by reliable sources to look to a Feb. 8^th speech by Deputy Governor Shinichi Uchida. He made it clear that incrementalism will be the watchword.

            One part of the BOJ policy is a slightly negative (-0.1%) rate on overnight funds that banks lend and borrow from each other. For most central banks, this is the major policy tool; the American equivalent is the “fed funds” rate. Today’s rate is down from the positive 0.1% rate the BOJ began during the global financial crisis of 2008. Uchida hinted that, whenever the BOJ finally moves, it might simply bring the overnight rate back to 0.1%. Moreover, its purpose would not be to tighten monetary conditions, but “to maintain the functioning of the money market,” whose smooth functioning has been somewhat disrupted by the -0.1% posture. Consequently, he continued, “it is hard to imagine a path in which [the BOJ] would then keep raising the interest rate rapidly. The Bank would, I think, maintain accommodative financial conditions.” Uchida noted that the financial markets are currently assuming it would take as long as two years for the overnight rate to hit just 0.5%. Furthermore, for years, real, i.e., after-inflation, interest rates have been substantially negative. In short, the nominal overnight rate is lower than inflation, adding, “This situation is not expected to change much.”

            The other question is what happens to long-term rates when the BOJ changes its policy of “Yield Curve Control (YCC). YCC means controlling not just overnight rates, but also rates all along the “yield curve,” i.e., on debt maturities ranging from overnight to 40 years, and particularly the 10-year Japan Government Bond (JGB) rate (see chart below).

Source: http://www.mof.go.jp/english/jgbs/reference/interest_rate/index.htm

YCC is contrary to the policy of most major central banks, which is to control only overnight rates and let the market determine longer-term rates. The BOJ implemented YCC by buying a flood of JGBs, making the BOJ the biggest holder of government debt (see chart at the top). Via the law of supply and demand, YCC lowered the interest rate on JGBs all along the yield curve. Since the BOJ began “tweaking” its policy in December 2022, the yield curve has gradually risen, as seen in the chart above.

            Uchida said it was possible that the Bank could either terminate YCC altogether or else continue it in some way. Either way, he stated that the BOJ must “maintain the stability of markets during that process... Of course, if the Bank does revise the [YCC] framework, it will incline more toward letting interest rates be determined by the market. In doing so, however, it will take careful measures...[to] make sure that the amount of JGB purchases will not change significantly and interest rates will not rise rapidly [emphasis added].”

            In short, any tweak will be just that: a tweak, not a big change.

Has BOJ Changed its View of The Greater Risk: Moving Too Early Or Too Late?

Central banking is a matter of balancing risks. In a world of uncertainty, it’s hard to get policy precisely right. So decision-makers try to reduce the size of inevitable errors. Is it more harmful to move too early or too late; is it worse to do too much or too little?

            For years—under both Haruhiko Kuroda and Ueda—the BOJ has insisted that it would be riskier to tighten too early than too late, and to tighten too quickly than too slowly. Moreover, it wanted more certitude that instead of inflation being caused by imported costs due to COVID-created supply disruptions, Japan was going to reach sustained 2% inflation led by healthy domestic demand including 3% nominal wage hikes. Up until now, including the Feb. 29 statement by Ueda noted above, the Bank has maintained that stance, a stance that seems reasonable in light of the wage and price trends. For example, over the past six months, the annualized inflation has come down considerably, with inflation except for food and energy having fallen to just 1.2% (see chart below).

Source: https://www.e-stat.go.jp/en/stat-search/file-download?statInfId=000032103842&fileKind=1

            At the same time, in an unfortunate spate of mixed messaging, the BOJ has been sending out signals of some change in its outlook on both of these issues, both in public statements and in private conversations with people in the financial markets. The contradictory signals have exacerbated inaccurate market expectations of an imminent change of policy before each of the BOJ policy meetings for the last several months.

            The last time Ueda spoke on the balance of risks between moving too early vs. too late was at a September 2023 press conference. He reiterated that moving too early would cause more harm. He also indicated that future events could alter the Bank’s assessment; if so, he would explain that change. Since then, Ueda has neither reaffirmed this view, nor announced any change, despite all the market speculation of an early change in policy. Does his failure to reaffirm it mean that the perception is no longer as powerful as it was? Or does his failure to announce any change mean that the perception has not changed? It’s very hard to tell.

            Most central banks these days believe their policy moves are more effective if they give clear signals to the market ahead of the move. Hence, it would be helpful if Ueda were to update his comments: is the greater risk moving too early or too late, or has the risk turned neutral?

            In any case, sources familiar with BOJ thinking say that a tweak of the policy in April is not out of the question, even if the likelihood is not as high as the market is betting. If you put that together with Uchida’s speech, the conclusion would be: if there is any tweak at all, it will be a relatively small one. And Ueda’s Feb. 29 statement would seem to indicate that the BOJ won’t move on March 19^th.

            Whatever the Bank does, or does not do, in March or April, market players are likely to complain even more about poor communication strategy (but not about their own wishful thinking, a situation which requires even more consistency by the BOJ).

Does BOJ Still Want Clear Evidence On Wages?

For a long time, the BOJ has insisted that Japan cannot have healthy 2% inflation led by domestic demand unless nominal wages grow by significantly more than 2%. Under Kuroda, 3% was the specified goal, while Ueda has not given out a specific number.

            Moreover, the Bank insisted that it needed solid evidence of sustained wage growth at the required level. However, in recent months, Ueda has undercut that stance. In a December 27th interview, Ueda said that it might be sufficient to see the results of this spring’s shunto negotiations on wages between the big companies and unions. “It’s possible to make some decisions even if the Bank doesn’t have the full results of spring wage negotiations from small- and middle-sized businesses.” The first shunto indicators are supposed to be announced around March 15. That’s one of the reasons so many traders expect a policy tweak on March 19 or April 27.

            Ueda’s comment is a clear deviation from past policy. A big wage hike in last year’s shunto led to expectations of sizeable hikes through the economy. But that failed to happen. Why should anyone believe that this year’s shunto results will be a better predictor of broader wage trends? This feels like yet another mixed message.

            In part 2, I’ll explore why conflicting evidence on wage trends makes it hard for the BOJ to have much certitude on future wage outcomes.