Kuroda’s next five years: Prepare to ease again

On February 9, the Japanese government leaked their intention to reappoint the BoJ governor Haruhiko Kuroda when his current term expires on April 8. What are the key challenges for Mr. Kuroda in the next five years?

BoJ unlikely to tinker with 10year rate target anytime soon

In the last few months, the market has been speculating if and when the BoJ decides to raise its 10-year interest rate target of 0.0%. We do not think it will happen anytime soon though. The problem of raising 10-year rate target is similar to the problem of devaluing a pegged currency. As soon as the market senses that the BoJ may raise its 10-year target rate from the current 0.0% to say 0.1%, there will be tremendous selling pressure in the bond market, and the BoJ has to counter it as the target has not officially been moved. Even after the target has been raised, the selling pressure will not stop as the market continues to expect a further hike. Through the process, the BoJ will be risking significant turbulence in the market. If the rate hike is unexpected and the hike is large enough to make the market believe that the next hike is far away, the turbulence above could be avoided, but such a secretive monetary policy change creates a large source of uncertainty in the future.

An alternative method to partially avoid the problem above could be to target a shorter interest rate, say 5-year interest rate. In this way, the BoJ does not need to keep the market in suspense for the next 10-year rate hike. However, this policy change again needs to be unexpected to avoid the large selling pressure in the bond market before the policy change announcement. All in all, tinkering with the current 10-year rate targeting regime seems quite precarious for the Bank of Japan, and we doubt if the BoJ would want to risk it in the early phase of an exit process.

Yen yield curve has hardly moved in 2017. Expect more of a same for 2018

Tapering ETF purchase is easier

In our view, the BoJ is more likely to start the exit by tapering its equity ETF purchases. Unlike the decision to change the interest rate target, the BoJ can gradually prepare the market before the announcement to reduce its ETF purchases. The negative impact on the equity market can be absorbed over time. In the ideal situation, the impact of the tapering could be fully priced in by the time the BoJ eventually announces the policy.

Inflation needs to rise by full 1% points before BoJ could consider tapering
In the press conference Mr. Koruda held after the policy meeting on January 23, he referred to the prevailing inflation rate of 1.5% in the U.S. and Euro area as the condition justifying a tighter monetary policy. In our view, even if the Japanese economy maintains the current above-potential growth speed through 2018-19, the earliest the inflation rate in Japan could reach 1.5% is in 2019. Under such scenario and provided that the stock market turbulence we saw in the past one week proves to be a temporary adjustment, we could start to hear BoJ officials floating the idea of ETF purchase tapering toward the end of 2018.

Core inflation is still mere 0.3%

Preparing for the next recession

What could the Bank of Japan (BoJ) do if it is to face a recession? The question is the most difficult and critical challenge for Mr. Kuroda in the next five years. It has already been ten years since the last global recession, and we should not be surprised to see another one around the corner. Assuming the current economic expansion to continue for another year or two, the BoJ may be able to start an exit process. However, if a recession is to happen within the next few years, we expect most of the current easing policies, such as the -0.1% short-term policy rate, to be still in place. We have listed options for the BoJ below. The most effective and the least painful for the Japanese policymakers is an FX intervention, but the yen has to strengthen by a large margin, say by 20-30%, for Japan to seek an international endorsement. Ultimately, the policy the Bank of Japan will probably need to resort to is a formal monetization of fiscal spending, casually known as “helicopter money.” While it may sound radical, we think it is only a logical conclusion for anybody who believes that the BoJ is unlikely to have achieved reflating Japan and normalized its monetary policy before the next recession hits the Japanese economy.

A list of easing policies the BoJ can implement

-Lowering short-term rate

As governor Kuroda himself has repeatedly said it may happen, the BoJ has an option of lowering the short-term interest rate. However, this option seems to have become too unwieldy for the bank of Japan. In theory, the lower short-term interest rate should weaken yen and lower the cost of borrowing. However, when the BoJ introduced the policy in January 2016, the effect on yen was ambiguous, and the negative side effects on bank stocks were quite widespread. Furthermore, when the flattening of the yield curve, with the 20yr rate falling to 0%, was too extreme even for the BoJ.

-More ETF purchases
Expanding ETF purchases is relatively easy to implement as it is an extension of an existing policy framework. However, if the BoJ is to double the pace of purchase from 6 trillion yen per year to 12 trillion, the BoJ would be purchasing roughly 2% of the Japanese stock market per year. The BoJ also has an accounting rule to realize losses when the total market valuation of its ETF holding falls below their book value. A sizable loss from its ETF purchases, perhaps leading to a technical bankruptcy of the BoJ if the size of the loss exceeds BoJ’s capital, can be politically too controversial.

-Adopting price-level targeting
The BoJ is partially adopting this policy by admitting an overshooting of 2% inflation target. A formal switch to a price-level targeting may be a significant event for a monetary policy regime, but the market is unlikely to be impressed.

-Purchase of foreign currency denominated debt
It will be tantamount to an FX intervention. If Japan is in the position to rationalize an FX intervention, it will probably be done through the traditional way, through Ministry of Finance.

-Explicit support for fiscal expansion
In the past cyclical downturns, the BoJ often announced expansions in its JGB purchases to implicitly help Japanese government issues JGBs to finance economic stimulus plans. Given that the BoJ is already monetizing the entire new JGB issuance, the BoJ needs to go further if it wants to impress upon the market that it is monetizing the public spending. Perhaps a joint statement by the government and the BoJ announcing the government’s intention to issue zero-coupon perpetual bonds, to be purchased by the BoJ.

-Helicopter money
In the simplest form, the BoJ needs to start handing out cash to its citizen directly, without the government’s involvement. While this would be operationally difficult, there are methods for the BoJ to implement the helicopter money in substance. For example, the BoJ can start to offer finance to banks at a negative rate so that banks can in turn offer loans to its citizen and companies at a negative rate. The bank of Japan already has a program called “Loan Support Program” in which the BoJ offers financing at 0.1% to banks to make growth-enhancing loans. The BoJ merely needs to reduce the rate to a negative rate to effectively start a helicopter money policy.

Reappointing Kuroda was a safe, but not a reflationary choice for PM Abe
In our view, the BoJ could be more proactive to reflate Japan, rather than to remain passive and wait for the next recession to hit Japan. Prime Minister Abe had a chance to appoint a new governor who could have infused a fresh momentum for Japan to reflate itself sooner but he, unfortunately, squandered the opportunity.