Blog BOJ Moves Toward Phasing Out Yield Curve Control The Bank of Japan announced changes that could allow its yield curve control program to expire gradually, if economic conditions are favorable.
July’s monetary policy meeting could well be remembered as the moment the Bank of Japan (BOJ) began phasing out its seven-year-old yield curve control (YCC) program, or at least took a major step toward an eventual exit. In our view, the changes in YCC could help the program phase out gradually as the conditions that prompted its creation (persistent low inflation and low growth) also diminish, without prompting a disruptive rise in yields. We also do not expect a significant adverse impact on global financial markets from the YCC changes. The BOJ said it is making YCC more flexible while maintaining the 0% target yield level for 10-year Japanese government bonds (JGBs). One major policy change is that the plus and minus 0.5 percentage points around zero will no longer be “rigid limits” but instead “references” in the bank’s market operations. The bank also raised the target level at which it would conduct a fixed-rate JGB purchase operation every business day, from 0.5% to 1.0% on 10-year JGBs. By way of background, the BOJ’s YCC was introduced in September 2016, eight months after the bank surprised markets by lowering its short-term policy rate to −0.1%. Then, in July 2018, the bank defined plus and minus 0.2% as limits for 10-year JGB yields. Further tweaks to the yield target band were made to pursue flexibility and sustainability of YCC: plus and minus 0.25% in March 2021 and plus and minus 0.5% in December 2022. A phaseout of YCC would help mitigate its inherent problems YCC has posed both benefits and drawbacks. The BOJ’s unique policy tool has been powerful in helping suppress long-term real market rates well below real neutral rates, contributing to depreciation of the Japanese yen, helping ease financial conditions broadly, and hence stimulating overall economic demand. However, one issue with YCC’s design is that it could become too stimulative once the BOJ’s 2% inflation target actually comes into sight: Real rates would tend to shift even lower with 10-year nominal yields capped and inflation expectations rising, suggesting the policy should indeed be adjusted so it is less stimulative, not more. This “procyclicality” is an inherent problem with YCC, and July’s BOJ statement suggests that mitigating this problem is the bank’s main motivation for its decision: “Japan’s recent inflation rates … are higher than projected in the April 2023 Outlook Report, and wage growth has risen …. If upward movements in prices continue, the effects of monetary easing will strengthen through a decline in real interest rates ….” As time passes and circumstances change, policies that once appeared appropriate often must adapt. What economists call “time inconsistency” can be disruptive for the markets and economy, and potentially damage a central bank’s credibility. BOJ Governor Kazuo Ueda had mentioned this in relation to YCC prior to becoming the central bank chief in April, and at the press conference following July’s meeting he again raised potential issues around the procyclicality of YCC. The BOJ’s risk assessment and narratives on its inflation outlook support the changes made to the YCC program. In the July 2023 Outlook Report, though the bank’s forecast for consumer price index (CPI) inflation excluding fresh food was slightly lowered to 1.9% year-over-year for fiscal 2024 and kept unchanged at 1.6% for fiscal 2025, the bank notes upside risk for 2024 inflation and removed a downside risk narrative from its 2025 forecast. An elegantly designed phaseout Keeping the 0% target for 10-year JGBs with plus and minus 0.5% references (no longer rigid limits) and the new 1% upper limit is an elegantly designed phaseout for the YCC, in our view. The limited history of central banks exiting rate cap policies suggests this move can be disruptive. Governor Ueda noted the examples of the U.S. Federal Reserve (Fed) in 1951 and the Reserve Bank of Australia (RBA) in 2021. The seemingly complicated new design for the BOJ’s YCC could be much less disruptive; we believe the BOJ may have addressed the procyclicality challenge before it becomes unmanageable. The BOJ would allow (or even welcome) 10-year JGB yields rising above 0.5%, as long as the nominal yield rise is due to higher inflation expectations consistent with the 2% inflation target and/or a healthy rise in real rates that reflects stronger economic growth. Under those conditions, the YCC program could automatically be phased out with little disruption to the markets and real economy. Or, in an adverse economic scenario where inflation rates decline and do not rise again to the 2% target, the YCC program could simply continue and suppress yields lower as needed. In essence, with July’s announcement we believe the BOJ has likely succeeded in limiting the risk of its policy being procyclical and disruptive in a successful inflation scenario, while retaining the powerful easing tool with the same yield target for an unwelcome back-to-deflation scenario. Short-term policy rate unchanged The BOJ kept its short-term policy rate unchanged at −0.1%. The bank likely needs more data to become confident that its 2% inflation target has been met in a sustainable and stable manner (a condition for its forward guidance) before considering a change. However, the market may start testing the BOJ on the short-term policy rate before too long. Inflation dynamics seem to be changing, even in Japan. Bottom line July’s BOJ decisions could likely turn out to be a phaseout of YCC. The bank would allow JGB yields to rise, if gradual and consistent with growth and inflation, with the new cap at 1.0%. One concern is whether JGB yields could reach 1% too soon, with momentum to rise further. We believe JGB yields will likely stay contained: If yields were to rise anywhere close to 1%, we would expect strong domestic demand for Japan duration would be enough to hold yields at that level for now – at least until the BOJ’s 2% inflation target is finally met. We also do not expect a significant adverse spillover to global financial markets from the BOJ’s YCC changes. Many Japanese investors have already offloaded a large quantity of foreign bonds as their currency hedging costs rose with the U.S. Fed and other central banks hiking their policy rates. This should help limit additional appetite for domestic investors to sell foreign bonds to buy Japanese bonds.
Blog April Inflation Report Unlikely to Alter Fed’s Path April’s U.S. inflation report likely offers some comfort to Federal Reserve officials, but rate cuts are unlikely until we see a more substantial deceleration in inflation.
Strategy Spotlight Income Fund Update: Capitalizing on the Global Opportunities in Fixed Income With the potential for higher-for-longer yields across countries, we see the global fixed income opportunity set as the most attractive in years.
Viewpoints Navigating the Challenges: EU Securitisation Regulation and Its Effects on Investors and Markets Regulation has transformed the EU securitisation market, but there are further improvements that can be made.
Asset Allocation Outlook When Markets Diverge, Opportunities Emerge Shifting dynamics among global economies and markets present a range of opportunities for multi-asset portfolios.
Economic and Market Commentary The Cost of Cash: A $6 Trillion Question In this PIMCO Perspectives, we examine how the return of elevated bond yields comes at an opportune time to consider shifting out of cash.
Blog The Fed: Stuck On Hold for Now Despite the reacceleration of inflation and enduring labor market strength, the Fed remains focused on downside risks.
Viewpoints Will the True Treasury Term Premium Please Stand Up? Various methods to estimate this key bond market gauge differ on details but appear to signal rising investor compensation.
Blog April Inflation Report Unlikely to Alter Fed’s Path April’s U.S. inflation report likely offers some comfort to Federal Reserve officials, but rate cuts are unlikely until we see a more substantial deceleration in inflation.
Blog The Fed: Stuck On Hold for Now Despite the reacceleration of inflation and enduring labor market strength, the Fed remains focused on downside risks.
Viewpoints Will the True Treasury Term Premium Please Stand Up? Various methods to estimate this key bond market gauge differ on details but appear to signal rising investor compensation.