'Winds of change': The Bank of Japan is facing a policy dilemma -- here's what could happen next

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  • Global bond yields continued to rise overnight in the wake of news the Bank of Japan may be considering a shift in policy.
  • CBA currency strategist Richard Grace said there are three competing challenges creating a “policy dilemma” for the BoJ.
  • Grace expects the Bank of Japan will announce a change to the negative interest rate settings currently in place to encourage bank lending.

  • Indications that the Bank of Japan may be considering a shift in policy has been a key talking point to start the week.

    Any change would be notable, given the bank has maintained its commitment to huge monetary stimulus measures in recent years, with no major policy tweaks since September 2016.

    However, CBA’s chief currency strategist Richard Grace says years of ultra-easy monetary policy has also created some unwanted side effects for the Japanese economy.

    Grace highlighted three structural challenges Japanese policy makers now have to grapple with.

    “The winds of change have been evident for some time, and the build-up of structural challenges will sooner or later bring the BoJ’s policy dilemma to a head,” Grace said.

    Negative bank deposit rates

    The introduction of a 0.1% negative interest rate for current account balances (CABs) held by financial institutions at the BoJ is now hurting bank profitability, Grace said.

    “According to our calculations, there is now ¥120 trillion ($US1.1 trillion) of reserve balances — equivalent to almost 22% of GDP — subject to a negative 0.1% interest rate,” he said.

    Source: CBA

    The BoJ has a “three-tier” interest rate system for CABs to encourage lending. But if Japanese banks are unable to lend the money, they are also banned from adjusting their reserve balances at the central bank, which means more funds subject to negative deposit rates.

    Yield curve control

    The BoJ introduced this program in September 2016, and said it would purchase as many government bonds as necessary in order to keep the yield on 10-year Japanese government bonds pinned at or near 0%.

    Back in January, the BoJ realised it could slow down bond purchases to around 40 trillion yen per month without affecting interest rates.

    But Grace said the total amount budgeted by Japan’s Ministry of Finance for the issuance of 10-year government bonds only amounts to 26.4 trillion yen for the 2018 fiscal year.

    “With BoJ purchases being concentrated in the 7-12 year range, there are not enough bonds being issued to keep up with the BoJ’s current purchase policy,” Grace said.

    And with the BoJ scooping up all that government debt, there’s a lack of safe domestic investment options for Japan’s huge superannuation funds to offset their pension liabilities.


    The main driving force behind the BoJ’s current policy stance is to get domestic inflation back to 2%. However, Japan’s ageing — and dwindling — population makes that “difficult, if not impossible”, Grace said.

    So while the size of the BoJ’s balance sheet is now equal to almost 100% of Japan’s GDP, Japan’s annual inflation rate remains stuck at 0.7%.

    Source: CBA

    Policy outlook

    Grace was hesitant to speculate on what the BoJ will do next, but said it will most likely address the growing balances held by Japanese banks which are currently subject to negative interest rates.

    “At the very least, the most likely policy change will be abandonment of the three-tier interest rate system on current account balances,” he said.

    However, any prospective changes to bond purchases or interest rate settings “will make it more challenging” to meet the 2% inflation target.

    Grace expects the US dollar to strengthen against the yen between now and next Tuesday’s BoJ policy meeting. Japanese inflation data due out this Friday will also take on an increased level of importance.

    For now, global bond markets continue to show signs of twitchiness in the wake of BoJ developments.

    Benchmark US 10-year bond yields rose by another seven basis points overnight to a one-month high of 2.96%, following a sharp climb on Friday night when the news first broke.

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