What can we learn about BoJ's policy?

Mr. Kazuo Ueda, BoJ Governor

>> BoJ’s phobia of tightening policy

We have spoken before about the similarities between the target band for 10-year JGBs that the Bank of Japan tries to maintain, and the exchange rate target bands that have been quite a common feature of currency markets for some time.

For instance, we have talked about how the removal, or widening, of FX target bands leads to a sudden jump in the currency and how that’s the same as the reaction we’ve seen when the BoJ has widened the target range for JGBs. We have also discussed how maintaining a currency target band can create interest rate volatility and asked whether the BoJ’s attempts to keep 10-year JGBs in a range 50-bps either side of zero has created extra volatility in the yen. It has, for if you take 3-month implied dollar/yen volatility it is around 3 vol over 3mth euro/dollar volatility right now, which is a very wide gap in historical terms.

But there is another sense in which we want to investigate the similarities by asking whether the maintenance of a target range, for either the currency or the bond market, creates what we’ve called policy obscurification by the central bank. If we think about the FX market, the existence of a target band does create an incentive for policymakers to be less helpful to the market than if they maintained a floating exchange rate.

To see this just think of those instances when a currency is right at the bottom of its band and the central bank insists it has no plan to devalue. Sometimes this is correct and the bank can fight off the speculators. But often it has to give in and, more to the point, probably knows beforehand that it will have to give in. It can’t, of course, admit that it will likely stop defending the currency at some point in the future because that would cause an immediate devaluation as market pressure would be overwhelming.

In short, the central bank has to say one thing when, in reality, it is almost certain that it will have to do another (devalue). Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said there is no reason why things are any different when it comes to an interest rate target band, such as the one the BoJ maintains for the 10-year JGB yield. In other words, we should expect the BoJ to say one thing, but likely do another. If this still seems unbelievable, just think about the Bank’s decision to widen the target band from 25-bps around zero to 50-bps last December. The Bank could not offer any forward guidance about this because it would have been overwhelmed by market pressure immediately. Hence, it had to maintain the pretence that there will be no policy change while, all the while, plotting a move. But shouldn’t the market be wise to this?

Yes, it probably is. For instance, while the specific December decision to widen the JGB target band was a shock, the market had a sense that there would be a change at some point – just as it does again now. It can’t really express this in the 10-year JGB market as that’s capped by the BoJ. But it can express it in the yen, which started to strengthen appreciably ahead of the December decision.

>> All eyes on BoJ’s actions

Of course, the market did not know that a decision was coming at the December BoJ meeting, but it believed that one was coming at some point. It is the same now and, in Mr. Steve Barrow’s view, one reason why we could start to see the yen strengthen again. Once again, the market will not know when the BoJ might make the next change in the yield curve control (YCC) policy and that might mean that yen bulls will have to be patient. But as long as inflation data stays elevated, and so refutes the BoJ’s view that it will quickly sink back below the 2% target, the patience of the yen bulls should be rewarded.

“As far as we can tell, any BoJ policy meeting from here is a ‘live’ one in terms of making another adjustment to the YCC policy, even if the BoJ says that it is off the table. In fact, the more it says that it is off the table, the more it is likely to be on the table”, said Mr. Steve Barrow.