25 April 2017
Bank of Japan (BoJ) has thrown the kitchen sink at Japan’s inflation problems, following years of criticism that it had been too timid. The monetary arrow of Abenomics has dwarfed the quantitative easing (QE) measures carried out by other central banks. The BoJ has expanded its balance sheet by 14% of GDP a year since 2013, significantly faster than that seen in the Eurozone, US and UK since the crisis (see Chart 7). This has taken the BoJ’s balance sheet to an eye watering 88% of GDP, well above the European Central Bank’s 34%, which is the next largest among the major central banks. The BoJ now owns around 40% of the stock of Japanese government bonds, alongside a range of assets from exchange traded funds to real estate investment trusts.
The BoJ has come up against two challenges. First, the results from its monetary expansion have been disappointing. While the Japanese economy does look to be making progress toward reflation, this has been frustratingly slow. Second, declining asset pools have naturally led to questions over the ability of the central bank to continue buying indefinitely. These forces triggered a shift in the BoJ’s policy approach to incorporate yield curve control, with the 10-year government bond yield not allowed to deviate far from 0%. In part, this new framework was designed to improve the sustainability of policy, with yield targets potentially providing the BoJ freedom to reduce the pace of asset purchases over time. This has not always been the case so far, with the BoJ often having had to defend its yield target when markets tested its commitment to this new policy (see Chart 8). We continue to believe that the short term commitment to the current yield target remains strong, with the triggers on the inflation side that would justify a change not materialising.
Kuroda was certainly right last week that it was “premature” to discuss any exit from BoJ stimulus. However, the size of the BoJ’s balance sheet does pose long-term challenges. If the central bank achieves its inflation objectives, then navigating an exit will require careful calibration. Balance sheet expansion has not as yet spurred financial imbalances or a rapid shift in inflation. However, the BoJ will need to be alert that this dynamic does not shift if we do see evidence of reflation setting in. On the flip side, if the BoJ were to unwind its balance sheet too quickly, helped by asset sales, this could lead to an aggressive tightening in financial conditions which could derail the economy. Moreover, the BoJ would risk making losses on its asset holdings, denting its capital position. Interestingly, it is already retaining a greater portion of earnings to try and build these buffers. In some regards these would be nice problems to have. If the BoJ’s reflation efforts prove unsuccessful then policy choices become even harder. A failure to exit current policy settings will extend and deepen the distortions in Japanese financial markets from asset purchases and yield targets. In particular, the BoJ’s policies embed easy financing conditions for the Japanese government, in spite of high public debt. If the government becomes ever more reliant on this support then the lines between fiscal and monetary policy will blur. This could threaten the independence of the central bank to follow its inflation targeting mandate. Instead, fiscal dominance could emerge, with the central bank under pressure to underpin the public finances.
James McCann, Senior Global Economist