New problems from yield curve control
by Sayuri Shirai
In September the Bank of Japan shifted its primary monetary policy instrument from the monetary base to the control of the yield curve, pegging the 10-year bond yield ‘around zero’.
Notwithstanding the de facto monetary tightening, the markets reacted positively to the BoJ action. This was reflected in a shift towards short positions in the yen and long positions in stock prices.
By implementing yield curve control, the BoJ abandoned the guideline for the average remaining maturity of Japanese government bond purchases. This was in the target range of seven to 12 years.
The intention of this guideline was to prioritise exerting downward pressure on longer-term bonds – reflecting greater monetary accommodation generated through flattening the yield curve.
Since the BoJ announced it would maintain annual government bond purchases of ¥80tn ($550bn) in 2017, yield curve control has implied fewer bond purchases for longer-term yields and more purchases for shorter-term yields.
By pegging the 10-year yield at around zero, the BoJ appeared to have prevented long-term government bond yields from falling excessively and prevented the yield curve from becoming too flat. These phenomena intensified after the BoJ adopted negative interest rates in January 2016.
This suggests that there is a threshold below which a further cut in government bond yields (and lending rates) no longer has a noteworthy impact on credit demand, aggregate demand, inflation, and inflation expectations.
Instead, smaller lending-deposit interest rate spreads became a growing cause for concern among banks. This is especially the case in the absence of strong credit growth with a low loan-deposit ratio (below 70%). Low returns on government bonds also worried banks, given that they had opted to hold government bonds to fill the gap between loans and deposits. Insurance firms and pension funds likewise suffered from low returns and higher liability due to a declined discount factor.
If such policies continue for a long time, the financial instability risk may rise. Yield curve control may therefore be viewed as the BoJ’s admission of potential adverse effects.
The Chart shows the yield curve at three specific dates: 27 January 2016, just before the announcement of a negative interest rate; 27 July 2016, just before the announcement of expanding purchases of exchange traded-funds; and end-February 2017.
The 10-year yield achieved its lowest level on 27 July. After this, the yield curve began to rise as markets anticipated the change in the monetary policy framework from volume-focused to yield curve control.
Macroprudential and monetary policy
Generally, central banks stress that monetary policy should prioritise price stability over financial instability risk. The latter should be dealt with by macroprudential policy, with monetary policy as a second line of defence. While desirable in theory, such a clear division may no longer be possible.
Central banks may no longer be able to monitor risks adequately – such risks may not be traceable or foreseeable, given the dominant impact of monetary easing on markets.
Although yield curve control deals with some adverse effects, it generates new potential problems. If the 10-year yield is kept at a rate that cannot be justified for too long from a credit risk perspective, the risk rises of undermining financial intermediation functions and delaying corporate sector restructuring. The government bond market has been distorted because price information is largely suppressed. The BoJ’s balance sheet risk is higher given that it may commit to buying government bonds in excess of ¥80tn annually in a phase of upward pressures on yields.
Eventually, the BoJ must choose between two options. The first is maintaining large-scale monetary accommodation for what is likely to be a shorter period. The second is reducing the degree of monetary accommodation somewhat and instead focusing on maintaining the new level of monetary accommodation for a longer period.
Since Donald Trump was elected president, higher US yields in anticipation of higher economic growth and inflation, together with yield curve control, have caused the yen to depreciate against the dollar. Japanese stock prices have risen, suggesting the markets consider yield curve control to be more effective than negative interest rate policy.
Nevertheless, it is important to recognise that monetary policy is overstretched and its impact on domestic demand has not been strong. By resisting higher prices, the public has shown that it does not support the 2% price target. It will therefore take more time for the BoJ to achieve inflation of around 2% and anchor long-term expectations at that level. In the light of this background, the BoJ should consider providing more reasonable projections for when it can achieve 2% and present a more sustainable monetary policy framework to meet this goal.
Sayuri Shirai is a Professor of Keio University, a former Policy Board Member of the Bank of Japan and an author of Mission Incomplete: Reflating Japan’s Economy. Back