Mar.25, 2014, 18:00 JST

BoJ should Twist and Forward

Summary

The Japanese economy is likely to stall following the consumption tax rate hike from 5% to 8% in April. What could the Bank of Japan do to reflate the economy? In our view, the BoJ can reallocate its JGB purchases toward longer maturity to flatten the yield curve, while maintaining the overall size of its JGB purchase unchanged. In addition, the BoJ should strengthen its forward guidance to anchor the future policy rate expectation that should keep short and medium term interest rates in check. Such combination of Twist operation and Forward guidance should lead to lower interest rates across the curve.

Japanese economy about to stall from April  

The Japanese economy will face a strong headwind through the course of 2014-2015. The Japanese government plans to tighten its fiscal policy by 3% of GDP in those 2 years, starting with the consumption tax rate hike from 5% to 8% in April 2014. The BoJ governor Kuroda, while maintaining that he thinks the negative effects from the tax hike on growth will be temporary, says that the BoJ is ready to make “adjustments” to the BoJ’s policy if necessary. In our view, the slump in the economy after April will prove to be greater than anticipated and the BoJ will indeed need to implement an additional monetary stimulus to support the economy. What more the BoJ could do? 

Stalling economy urges the BoJ to ease again

As the choice of Mr Kuroda’s word “adjustments” indicates, the additional easing measures are likely to be an extension of the current easing framework. In the current policy framework, the BoJ buys a wide array of assets, ranging from Japanese government bonds to corporate bonds, CPs, equity ETF and J-REITs. In the next round of stimulus, the BoJ will probably nominally increase its purchase across all these assets, but the emphasis will be on its JGB purchase program.

BoJ should reallocate its JGB purchases to longer end    

The short to medium term interest rates are already close to zero, but the longer end of the JGB curves offers additional room to flatten. Lower long term interest rates will benefit borrowers as well as help to redirect private investments from JGBs to other riskier asset types. In order to flatten the yield curve, the BoJ does not need to increase the overall size of its monthly JGB purchase. Of the total of 6.5 trillion yen JGB purchase per month, the BoJ allocates 3 to 4 trillion yen toward JGBs with less than 10 years remaining maturity and only 1 to 1.5 trillion yen toward JGBs with more than 10 years remaining maturity. By redirecting 0.5 trillion yen from the former category to the latter category, the BoJ can increase the average maturity of its purchase from current 7 years to 9 years. In light of the BoJ’s rapidly rising ownership in the JGB market, it would be prudent not to increase the overall JGB purchase size. In U.S., the Federal Reserve implemented a similar “twist” operation in 2011.

BoJ should strengthen its forward guidance   

We also think that the BoJ could make its monetary policy more effective by strengthening its forward guidance. Currently, the BoJ’s forward guidance is fairly vague. The current monetary policy statement says “The Bank will continue with quantitative and qualitative monetary easing, aiming to achieve the price stability target of 2 percent, as long as it is necessary for maintaining that target in a stable manner”. The statement leaves a room for market participants to speculate that the BoJ may discontinue with its easing if the bank achieves its 2% inflation target as early as in 2015. In our view, the BoJ will likely need to maintain an easy monetary policy stance for a measurably longer period, perhaps till 2020. In order for Japan to conclusively dismiss the risk of deflation, we think it is necessary for Japanese economy to demonstrate that it is resilient against the risk of fiscal tightening. We do not think Japan can credibly claim that it is regaining fiscal sustainability before 2020. In our view, the BoJ should provide more explicit forward guidance to anchor the market expectation for future policy rate. 

BoJ should ease sooner rather than later 

Once the economy start to deflate, it would be harder for the monetary policy alone to reflate it again. While Mr Kuroda maintains that the economy is likely to accelerate again after July-September quarter of this year, we fail to see what private demands could come to the rescue once Japan’s private consumption start to stall. In our view, Mr Kuroda should decide ease as soon as June this year. Delays will only result in greater need for eventual monetary and possibly fiscal stimulus.