- In order to boost inflation expectations and inflation, the Bank of Japan has made two changes to its monetary policy.
- By introducing yield targeting, it creates more flexibility than would a QE policy.
- Importantly, it has committed to overshoot its inflation target. However, judging by the reaction of the USDJPY exchange rate, the market was not impressed.
Central bank credibility is a necessary condition for monetary policy to be successful in achieving its objectives. It refers to the authority (independence) of the central bank to act when circumstances require and to its willingness and ability to take the appropriate measures. A credible central bank will succeed in influencing behaviour of households and companies in such a way that its inflation goal (along with other goals, if any, as well) is met and is expected to be met also in the future: inflation expectations are well anchored. If progress towards reaching the objective(s) is too slow, doubts about the effectiveness may creep in, inflation expectations may become unanchored and the central bank might lose some of its credibility, rendering its monetary policy less effective. This risk is all the more real if financial markets are under the impression that time is running out, i.e., that there is a risk of running out of ammunition.
Bank of Japan introduces yield targeting
The decisions taken by the Bank of Japan (BoJ) last Wednesday need to be seen against this background. The introduction of “yield curve control”, including targeting the 10-year yield on Japanese government bonds (JGBs), reflects multiple concerns: 1. inflation is still too low compared with the objective, and inflation expectations have declined, 2. a volume-based monetary policy (buying a certain amount of JGBs or other instruments per month) would become increasingly difficult to maintain as the remaining stock of JGBs declines, 3. in a traditional QE policy, the market determines the shape of the yield curve, and an excessively flat curve would end up having a detrimental impact on banks and insurers, 4. related to this, should the BoJ eventually decide to lower the negative rate further on policy-rate balances in current accounts held by financial institutions at the BoJ, a policy of targeting the 10-year yield would make it possible to soften the impact on the financial sector by maintaining a sufficiently steep curve and 5. finally, creating more flexibility with respect to the volume target (although surprisingly the BoJ refrained from dropping this target altogether) could increase the market impact of its operations by exploiting the surprise factor.
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by William DE VIJLDER