How will the BOJ adjust its monetary policy?

 Mr. KURODA Haruhiko, BoJ Governor

Advanced-country central banks have a lot on their plate at the moment. Inflation is soaring while recession risks are rising. Fortunately, virtually all of them don’t have to worry about volatile and disadvantageous currency moves. We say "virtually all" because the Bank of Japan seems to have a problem with the yen. While this could cause the BoJ to adjust policy as soon as possible, it seems more likely that this concern over the yen is not that pressing at all, and the bank will just have to live with whatever the FX market throws at it.

It does not seem that long ago that BoJ policymakers complained that excessive yen strength was undermining the bank’s fight to rid the country of deflation. Today it seems that the bank’s concern is that an excessively weak yen is generating too much price pressure. This might not be very evident at the CPI level- yet- as prices are still not running above the 2% target (although they soon will be). Instead, it is prices at the PPI level that are concerning, with the annual rate of 9.5% in March being the highest since the early 1980s.

If the bank were really focused on trying to stop the yen weakness that seems to be exacerbating the surge in inflation caused by higher commodity prices, then it would probably tighten policy. After all, it does seem as if a good part of the yen’s weakness is due to the fact that many other central banks are tightening aggressively, like the Fed, but the BoJ is not.

However, we also have to consider the trade effects of the conflict in Ukraine. As a significant net commodity importer, particularly of energy, Japan was always likely to face some currency pressure. Countries that have a far healthier commodity export position, including the US but also the likes of Australia and Canada, have seen currency strength, particularly against the yen.

In Mr. Steve Barrow, Head of Standard Bank G10 Strategy’s view, it is this terms of trade issue that has weighed primarily on the yen, through a collapse in its trade balance (that was already suffering because supply chain fragmentation was hurting car exports). Hence, even if the BoJ were to tighten policy in some way, there’s no guarantee that it would lift the yen beyond any initial knee-jerk response, particularly if commodity prices continue to rise.

But even if it is debatable whether tighter policy would lift the yen, there might still be a case for acting, if only because 10-year JGB yields keep bumping up against the 0.25% ceiling that the BoJ has set. As a result, it is being forced into numerous rounds of unlimit ed 10-year JGB buying to keep the yield within the target range.

At the moment, we don’t have the sense that this is proving particularly onerous. But if we see international yields continue to rise, particularly in treasuries, and as domestic CPI inflation vaults past the 2% target, it could become harder and harder for the BoJ to hold the 10-year JGB target band. Alternatives include widening the band, as the BoJ has done before, or shifting the target to the shorter-end of the curve, perhaps 2 year or 5 year JGBs. This latter option seems to be the one that could be considered, but even this is not without its drawbacks, "Mr. Steve Barrow said.

The Reserve Bank of Australia used a 3-year yield target, set at the same level as the key policy rate, to signal that policy rates were unlikely to be hiked for three years. But this had to be abandoned when the market broke the yield target and the RBA itself started to accept that the first rate hikes would likely start well before the expiry of these three-year bonds.

In short, if the BoJ were to pull the yield target into short-term bonds, it runs the risk of giving a false impression of the longevity of current policy rates. Despite this problem, Mr. Barrow thinks that the BoJ may be best served by shifting the yield target to the front end of the curve, if only because such action could essentially be forced on it by the market in the future if US rates rise sharply and/or the yen plummets. "We would admit that such a change is a less-than-even possibility at tonight’s meeting, but yen bears might still want to cover their short positions just in case," Mr. Steve Barrow said.