The writer is an FT contributing editor and global chief economist at Kroll
The Bank of Japan shocked markets in December by widening the band in which 10-year government bonds could trade from 25 to 50 basis points. Investors responded by pushing two- to 10-year yields to their highest since 2015, betting that the widening was the first step in ending yield curve control, the bank’s pledge to buy as many bonds as necessary to cap borrowing costs.
Yet BoJ governor Haruhiko Kuroda was at pains to say it was simply an effort to aid market functioning rather than a signal of a policy change ahead. Why?
Yield curve control was introduced in 2016 to boost economic activity and spur inflation. Japan now has inflation consistently above its 2 per cent target. The core inflation rate (excluding fresh food but including energy) rose to 3.7 per cent in November — the highest in 40 years. It’s time for the BoJ to summon up the courage to change course.
Based on the experience of other central banks that will be painful, with investor losses and market ruptures. The longer the wait, the worse those may be. Because liquidity in some Japanese government bonds is already thin, at a time when global liquidity is falling, market dislocations may be bigger and swifter than usual. The BoJ should push ahead anyhow.
Markets, so far, seem to agree. JGB futures show investors expect the 10-year trading band to widen by another 50 points this year. Index swaps, a market the BoJ doesn’t influence directly, show they have also priced in 24 basis points of rate rises. The BoJ now owns more than half of the outstanding JGB issuance. That’s already thinned trading in the 10-year. If investors continue to challenge the BoJ, it will eventually have to buy all the bonds or give up
Meanwhile, implied volatility for 10-year JGBs over the next 12 months is roughly three times what it was a year ago. The yield curve is kinked, with the 10-year yield falling below 9- and 11-year yields. That affects commercial bank profits, creating a disincentive to lend, potentially sapping growth.
The government of Prime Minister Fumio Kishida has suggested it will call for a BoJ policy review when Kuroda retires in April. That’s another reason for the central bank to act now. Markets will digest a policy change more smoothly under a seasoned governor with credibility than an inexperienced successor. Just ask members of the then-brand new Mexican government that widened the band in which the peso could trade in 1994, kicking off the tequila crisis.
One counter argument is that Japan’s inflation is unsustainable. As elsewhere, the current spike was driven by global energy and food prices and a weak currency — so-called cost-push inflation. BoJ officials contend deflation won’t be vanquished until wages rise faster, but this year’s spring shunto trade union pay negotiations are expected to bring larger wage hikes to compensate for higher inflation. This would generate the kind of demand-pull inflation that the BoJ wants to see.
The BoJ should also tighten policy before many developed economies are pitched into recession later this year. Risk-off markets tend to spark a flight to quality into yen. Shifting the policy stance as the global economy weakens would reinforce yen appreciation, dragging on Japan’s export competitiveness and contributing to disinflation.
History suggests ending yield curve control won’t go smoothly. The Federal Reserve capped yields to finance the US war effort from 1942 to 1951. That YCC lulled businesses into assumptions about interest rates and their volatility that broke down when the caps ended, causing losses for investors holding longer-term bonds and sharp dislocations in mortgage markets. The Reserve Bank of Australia practised YCC from March 2020 to November 2021. In a postmortem of its policy, the RBA admitted keeping it in place after market participants stopped believing in it meant “the exit in late 2021 was disorderly and caused some reputational damage to the Bank”.
To minimise disorder, the BoJ should be clear about its reaction function and move slowly but deliberately by first further widening the YCC band or targeting a shorter duration. Ultimately, it must announce that it is abandoning YCC entirely and will instead aim to minimise rapid changes in debt prices, such as those seen in the UK government bond market in September.
It is inevitable that there will be market spillovers. But the BoJ must stay the course, barring any kind of systemic meltdown. It’s time for it to join every other major central bank in moving to end extraordinary monetary policy.