Bank of Japan’s Monetary Target Under Discussion in Policy Review: Sources, Reuters

By Leika Kihara

TOKYO – The Bank of Japan (BOJ) is poised to reconsider its strategy for expanding base money through extensive asset purchases, according to sources, but must navigate the fine line of avoiding disruption in the bond markets accustomed to years of unprecedented intervention.

Last month, the BOJ announced a comprehensive review of its policies and their impact, prompting a swift sell-off in bonds as investors speculated that the central bank, facing diminishing policy options, might reduce its government bond purchases. Currently, the BOJ is acquiring approximately 110-120 trillion yen in bonds annually to fulfill its commitment to increase base money by 80 trillion yen each year.

After initial success in its asset-buying initiatives aimed at combating two decades of deflation, inflation rates have started to decline again. Sources revealed that the BOJ has prepared a preliminary framework for the review, indicating its intention to maintain the 2 percent inflation target.

This suggests that the review may lead to minor adjustments in the existing “quantitative and qualitative easing” (QQE) program, which integrates bond purchases with negative interest rates. Such adjustments could involve altering the average duration of the bonds held by the BOJ, currently between seven and twelve years, to grant the central bank greater flexibility in its buying decisions based on market conditions.

However, insiders indicate that a more substantial restructuring of the program is also a possibility. One approach might involve shifting the focus from base money to long-term interest rates, alleviating the pressure on the BOJ to sustain current levels of bond buying, which may soon deplete available market supply.

“The BOJ is in a challenging situation, needing to prolong the effectiveness of QQE,” remarked one source. “Revisiting the base money target could provide a viable solution.”

LONG-TERM TARGET

The notion of reassessing the base money target, suggested by various former BOJ officials, has gained traction among some current members who question whether additional money printing will effectively achieve the 2 percent inflation target. Hideo Hayakawa, a former top economist at the BOJ, argued that if the bank’s primary objective is to lower long-term interest rates, establishing an interest rate cap could be a logical strategy. Given the BOJ’s substantial holdings of government bonds, he believes it could likely keep yields depressed without needing to purchase additional bonds.

This approach may be particularly beneficial for Japan, which grapples with a significant fiscal deficit, according to Hayakawa, whose opinions are closely monitored by current policymakers.

At present, there is no consensus on how the review will influence monetary policy or whether this approach will gain traction as discussions intensify. However, the undertaking underscores a growing sentiment within the BOJ that adjustments to QQE are necessary.

SUPPLY CONSTRAINTS

The BOJ already controls about one-third of the government’s bond market, and the International Monetary Fund has cautioned that the central bank may face a shortage of bonds available for purchase in the near future. Some board members, including former market economists, have expressed concerns about the adverse consequences of extensive bond buying, such as diminished market liquidity.

With prices continuing to decline three years into QQE, confidence within the BOJ that expanding money supply will influence inflation expectations appears to be waning. All these factors amplify the appeal of moving away from the base money target, although there is a risk of triggering a sell-off in the government bond market if traders perceive it as a withdrawal of the BOJ’s stimulus efforts.

To mitigate this risk, the BOJ could consider committing to maintaining long-term rates below a certain threshold. Nonetheless, some officials worry that such changes might negatively impact already fragile inflation expectations.

Deputy Governor Kikuo Iwata, who played a key role in developing QQE, firmly believes that increasing money supply will lead to higher inflation, which could pose resistance to altering the base money target.

Nevertheless, this idea would provide the BOJ with greater flexibility in its bond purchasing strategy, as a rapidly growing balance sheet increases potential losses stemming from significant declines in bond prices.

While uncertainty remains about whether a cap on long-term rates would be effective, discussions regarding the future of the base money target are likely to take place in the coming months.