March 16 2017, 22:00 JST

BoJ Kuroda implies a high hurdle to change 10 year rate target

During the Q&A session following the BoJ policy meeting on March 16, the press repeatedly asked Governor Haruhiko Kuroda for clues on what would prompt a change in the BoJ’s target for the 10-year interest rate. In answering the question, Governor Kuroda pointed to factors affecting the medium-term inflation pressure such as the output gap, the inflation expectation and the underlying economic conditions. Governor Kuroda also emphasized that overseas factors such as Fed’s rate decisions are less relevant. When asked about the relationship between interest rate spreads and the exchange rage, he downplayed the importance of the interest rate spread as a determinant for the exchange rate and said he was confident that the BoJ can continue to control 10yr interest rate no matter what happens to overseas interest rates.

If we are to believe Governor Kuroda, the BoJ is unlikely to be changing its 10-year interest rate target for some time. According to the recent estimate by the Cabinet Office, Japan’s output gap remains negative at -0.4% in the last quarter of 2016. It will require two years of a well-above-trend growth for Japan for Japan to achieve an output gap that could produce any meaningful inflationary pressure.

Japan is still long way from having an inflationary output gap

As for the inflation expectation, the direction in the past 2 years has been downward. According to a survey conducted by the Cabinet Office, the percentage of the population who expects the price to go up shot up between 2012 to 2013, but it has been gradually declining in the past two years. It will probably require a sizable positive shock to stoke up the inflation expectation again.

Inflation expectation has been waning in the last 2 years

In our view, the BoJ is again risking its credibility by linking its 10-year rate target to factors such as output gap and inflationary expectation and ruling out overseas factor. Unlike the short-term rates that the BoJ can directly control, the long-term interest rates have to be controlled by interventions in the market. In case the long-term interest rates face a strong upward pressure from an overseas factor, such as a heightened inflationary concern in the United States, the BoJ will be forced to buy up bonds. With the BoJ already owning over 40% of the whole JGB market, the BoJ will be forced to drain up the remining liquidity in the JGB market.

BoJ already owns well over 40% of the whole JGB market

The Governor Kuroda was also asked on the relevance of the financial prudence of the BoJ’s balancesheet to the monetary policy. The Governor Kuroda initially took a softer approach, admitting that the balancesheet prudence is a factor to consider for the BoJ, but then ruled out a need for an agreement with the government on the contingency plan for a capital shortfall. As the BoJ continues to accumulate risky assets such as equity ETFs and long term bonds, the risk for the BoJ to incur a large enough loss to impair its capital is increasing. For example, at the current pace, the BoJ will have accumulated over 20 trillion yen worth of equity ETFs by the end of 2018. By then, a market crash will wipe out the capital of the BoJ. Without a clear contingency plan, the independent of a monetary policy can be put into questions.

Bank of Japan Balancesheet

Lastly, one of the reporters asked the Governor Kuroda for his thought on his chance of being reappointed to a second term when his term expires on April 2018. He had no comments on the question, but his expression seemed to imply that he may be willing to be reappointed.