A hearing on the Bank of Japan’s (BoJ) nominee for the next governor, Kazuo Ueda, was held in Japan’s House of Representatives on February 24, 2023. First, Mr. Ueda, a former member of the BoJ’s Board of Governors and an economist, expressed the same view on inflation as the current BoJ, specifically, that the current price increases are not “due to strong demand” and that “it will take time to achieve the 2% price target in a sustainable and stable manner.” This suggests that the inflation rate will likely fall below 2% by mid-year. Ueda then recommended that the BoJ continue its current super accommodative monetary policy as “a necessary and appropriate approach in light of the economic and price situation.” However, he also acknowledged the side effects of the policy and mentioned the possibility of a flexible review of the Yield Curve Control (YCC) program. On the other hand, if the 2% inflation target is achieved in a stable manner, the BoJ could reduce its purchases of Japanese government bonds (JGBs) without any sales of JGBs and take other steps to “exit” from the current framework.
Based on Ueda’s comments, it seems that the BoJ under his leadership would continue monetary easing until the inflation target is achieved in a sustainable manner, while at the same time seeking a new framework that can accommodate future price hikes. To achieve this, it will first be necessary to sort out theoretically the current policy framework, which has become extremely complicated.
Currently, the BoJ’s monetary policy can be described as “quantitative and qualitative monetary easing with YCC.” It combines quantitative targets, such as the amount of asset purchases and the monetary base along with interest rate operation targets, such as the short-term interest rate (the interest rate applied to the BoJ’s current account), and the long-term interest rate (the 10-year JGB rate). But, where did this complexity come from?
In April 2013, when the BoJ introduced “quantitative and qualitative monetary easing” with the goal of achieving the 2% inflation target, the bank started its reflationary policy by changing the operating target for money market adjustments from the unsecured call rate to the monetary base. However, in September 2016, the BoJ changed the interest rate targets for money market operations from the monetary base to the interest rate targets for the BoJ’s current account and the 10-year JGB rate.
While it would have been easier to understand if the BoJ had set only the interest rate on current accounts as the operating target for money market operations, the addition of the 10-year JGB rate to the operating target has complicated matters. This is because control of the 10-year JGB rate assumes that the BoJ will accept quantitative expansion of its balance sheet, such as purchases of long-term JGBs through fixed-interest rates operations with no upper limit on the amount of purchases. Furthermore, it is unclear whether the “overshooting commitment” regarding the 2% inflation target means the continuation of “quantitative and qualitative monetary easing with YCC” or the expansion of the monetary base.
This mix is mainly due to the fact that the evaluation of monetary policy that revolves around the monetary base has remained ambiguous. In terms of pure policy evaluation, the policy of using the monetary base as the operating target of financial market adjustment was probably difficult to evaluate positively in terms of its effectiveness and sustainability. This is why we believe a shift to a policy based on YCC must have been made in September 2016. However, perhaps considering that the Abe administration at the time firmly believed in the reflationary policy, it dared to choose the coexistence or mixture of quantity and interest rates, rather than a change from quantity to interest rates. Such a choice, or revisionism based on infallibility, is probably the reason why the policy became unnecessarily complicated without theoretical consistency.
In a 2012 paper titled “Japan’s Deflation and the Bank of Japan’s Experiences with Non-traditional Monetary Policy,” Ueda evaluates the BoJ’s quantitative easing and other non-traditional monetary policies during the period of 1998-2006. According to Ueda, the quantitative easing portion of policy can be divided into three categories: QE0, which is purely aimed at expanding the central bank’s balance sheet; QE1, which is the purchase of assets with an increased risk/liquidity premium; and QE2, which is the purchase of assets to encourage portfolio rebalancing through the purchase of long-term government bonds and other measures. He concludes that there is some evidence for forward guidance as well as for QE1 and QE2 (but QE1 is better than QE2 in terms of effectiveness). However, he cites no clear evidence for QE0. He also points out that the BoJ’s balance sheet reduction process since 2006 has been mainly driven by the reduction of short-term assets, but there was difficulty with asset reductions of long-term JGBs and equities. This suggests that future large purchases of such assets may make exit strategies more difficult.
After Ueda wrote the paper in 2012, the policy framework became even more complex. An explicit inflation target was introduced in 2013, negative interest rates were first used in January 2016 and YCC began in September 2016. However, it is possible to divine the direction of future policy revisions based on the assessment in his paper. The policy tools he considers necessary include the following. First, the 2% price inflation will be retained as long as it remains a medium- to long-term target. Second, forward guidance, which he creates, will be actively utilized. Third, asset purchases to contain risk and liquidity premiums are also likely to be implemented. On the other hand, the largest potential problem for him is the QE0 portion mentioned earlier, i.e., excess reserves in the BoJ’s current account, which has grown to a huge size through the purchase of JGBs of all maturities and at low interest rates. Not only will the effects of monetary easing be difficult to confirm, but the interest payments on the BoJ’s excess reserves will be so large that they are likely to become a major obstacle to any tightening when rates need to be increased due to rising inflation.
Our conclusion is that the new BoJ led by Ueda is likely to continue monetary easing by, for example, strengthening forward guidance by tying the “overshooting commitment” to the interest rate attached to the BoJ’s current account. On the other hand, the BoJ may consider (1) taking actions such as reducing excess reserves to enable an increase in the level of the interest rate on interest-earning assets in the event that monetary tightening is necessary and (2) discussing with the government (Accord) fiscal allowances for a deterioration in the BoJ’s balance sheet in the event of an interest rate hike in the future. Finally, although there are high market expectations for the elimination of YCC, we think that rather than a sudden elimination, it is likely that the bank will hasten to ease the degree of control to the extent that it can escape market pressures. Then it must decide how to handle YCC in the future within the larger context of reducing excess reserves.
For now, the market views Ueda as dovish because it sees him taking over what Kuroda has done and maintaining a similar path. However, it seems likely that the BoJ will eventually move away from a framework based on the size of the monetary base using YCC. This direction, which currently seems to be underestimated by the market, should support the yen’s appreciation.