Kuroda’s ground rules for policy discussion

Posted on September 6th, 2016

The speech by BoJ Governor Kuroda indicated that the Bank will stick to a 2% inflation objective and aim to achieve it at the “earliest possible time”. And also assured us that the “level” of monetary policy accommodation will not be reduced.  However, the speech suggested that the Bank would consider changing the mix of policy (perhaps lowering to NIRP further while reducing the amount or maturity profile of asset purchases). Kuroda continued to argue that there was ample scope to further ease policy across all dimensions of quality, quantity and negative interest rates.  However, the issue is not about limits to policy but the costs and benefits of these measures.  Kuroda admits there are costs of maintaining the current policy stance and extending it further and this must be weighed against the benefits.  Nevertheless, he strongly suggested that the benefits at least outweigh the costs of existing policy.  The speech highlighted costs associated with the flatness of the yield curve suggesting the bank would look at ways of mitigating these costs. 

The speech did not suggest that the BoJ needs to significantly increase overall policy easing measures.  Kuroda sees the economy close to full employment and the adaptive nature of Japan’s inflation expectations suggests that they should rise as the oil price effect on inflation dissipates.  As such there is no sense of urgency to further boost easing, only to maintain a strong commitment to the 2% inflation target at the earliest possible time. 

Noticeably absent was any reference the JPY exchange rate and the dampening impact its strength has had on inflation or the effectiveness of monetary policy.  This suggests that the topic of intervention is too politically sensitive and any policy of buying foreign bonds is off-limits.  Furthermore, Kuroda dismissed the possibility of helicopter money policy as essentially illegal and undesirable. 

The speech provides little impetus to weaken the JPY.  However, it does leave the door open for a modest further reduction in interest rates, which combined with a somewhat higher outlook for US rates and a more balanced positioning after the steep rise in JPY this year, may help stabilize the JPY exchange rate and weaken it modestly.  The Japanese yield curve has already steepened over the last month or so since the 29 July policy meeting, and this speech gives some additional support for this trend.


2% objective and level of MP easing to stay

In his speech on Monday BoJ Governor Kuroda sad that, “With the results of the assessment, the Bank will discuss what should be done in order to make sure that the price stability target of 2 percent is achieved at the earliest possible time. Let me emphasize that the assessment is conducted with the aim of achieving the 2 percent target at the earliest possible time. A reduction in the level of monetary policy accommodation, which is being called for by some market participants, will not be considered.”

So the objective is still to achieve the 2% price stability target at the earliest possible time (although earlier references to a 2-year horizon were omitted from the speech). And a reduction in the “level” of accommodation “will not be considered.”

The “level” may not be reduced, but this could mean a change in the mix of policy, with some elements reduced and others increased.


No sense of urgency to increase policy easing

Kuroda said, “The unemployment rate has declined recently to 3 percent, which is virtually full employment. As for wages, the annual labor-management wage negotiations in 2014 resulted in base pay rises for the first time in two decades; base pay rises have continued for three consecutive years.”

This suggests that Kuroda thinks conditions are at hand that can begin to generate more consistent inflation.  As such, he may not feel compelled to significantly increase monetary policy accommodation.

Kuroda spoke extensively about Japan having largely “adaptive” rather than “forward-looking” inflation expectations.  As such, the recent falls in inflation expectations relates much to the observed lower inflation outcome over the last year due to “the decline in crude oil prices and the temporary weakness in demand”.

On the other hand, these “adaptive” expectations imply that as the dis-inflation from lower oil prices dissipates, expectations will rise again.

As such, to some extent, Kuroda is not panicked by recent low measures of inflation expectations and is prepared to wait for these to rise as more stable to higher oil prices in the last year start to lift observed year-ended inflation.

He said, “Going forward, the underlying trend in inflation is expected to rise as the economy continues to grow at a rate above the potential growth rate and the effects of the decline in crude oil prices are expected to dissipate.”

“Therefore, the observed inflation rate is expected to rise gradually. Under these circumstances, inflation expectations will be pushed up by the “adaptive formation mechanism.”

However, Kuroda is not completely nonplussed by recent low inflation outcomes and low inflation expectations.  He sees risks that these adaptive expectations will not rise much, and he wants to push up inflation expectations by influencing those latent and fledgling forward-looking expectations.

He said, “For the time being, however, the observed inflation rate is unlikely to accelerate, hovering at slightly negative or about 0 percent. As a result, there is considerable uncertainty about the extent to which inflation expectations will rise through the “adaptive formation mechanism.” Against this background, it is imperative for the Bank to firmly maintain its commitment to achieving the price stability target of 2 percent at the earliest possible time from the viewpoint of the “forward-looking formation mechanism.”


NIRP effective to-date, but costs may limit effectiveness in future

In speaking about Negative Interest Rate Policy (NIRP), Kuroda said, in conjunction with Quantitative and Qualitative easing (QQE), it “has proven to be extremely powerful.”

He noted that since NIRP was introduced on 29 January, “banks’ lending rates, as well as interest rates on corporate bonds and CP, fell significantly, each marking historical lows. The pass-through of the decline in JGB rates to these funding rates since the introduction of the negative interest rate policy has been roughly similar to changes in previous episodes of interest rate cuts.”

“Moreover, new developments relating to corporate finance have been taking place recently; both the issuance of corporate bonds with a maturity of over ten years and firms’ borrowings through subordinated loans have increased.”

Kuroda further noted that while bank profitability had declined, there had not been a tightening in lending conditions.

He said, “Financial institutions’ lending attitudes have continued to be proactive. Thus, we are not in a situation where their intermediary functions are impaired because their profits are squeezed as a result of the negative interest rate.”

However, these were the facts to-date, and Kuroda acknowledged that extending NIRP policy further may be less effective.  He said the effects on bank profitability must be taken into account.  And the negative effects will increase the more prolonged is NIRP.

He said, “In assessing the effectiveness of the negative interest rate policy, the potential impact on the financial intermediation due to its influence on the profits of financial institutions needs to be taken into account. Considering that the profits affect the soundness of financial institutions in a cumulative manner, the impact can vary depending on the duration of the policy.”


Curve flattening increases costs of policy

He noted that the flattening of the yield curve has undermined bank profits, and Japanese bank profits are more susceptible to the dampening effects of NIRP since they have a larger share of deposits on their balance sheet than in other countries.

Kuroda said, “Given that the rates on deposits — which are the main funding tools — rarely become negative, the decline in yields throughout the entire yield curve or the narrowing of the spread between short- and long-term yields will lead to smaller spreads between deposit and lending rates, thereby negatively affecting the profits of financial institutions. For Japan in particular, the impact of the negative interest rate policy on the profits of financial institutions tends to be relatively large, due to such factors as the amount outstanding of deposits far exceeding that of lending, and to the spreads between deposits and lending rates already being extremely small following prolonged competition among financial institutions.”

He also noted the dampening impact of yield curve flattening on profits at insurance companies and pension funds, including companies that set aside profits to fund pension liabilities.

Kuroda said, “As long-term and super-long-term rates have declined significantly since the introduction of the negative interest rate policy, the rates of return on investments of insurance and pension products are expected to decline. Under these circumstances, the sales of some saving-type products are suspended. Some business firms have revised down their profit forecasts due in part to the increase in the net present value of retirement benefit obligations. Although direct impacts of these developments on the entire economy may not be substantial, we should take account of the possibility that such developments can affect people’s confidence by causing concerns over the sustainability of the financial function in a broad sense, thereby negatively affecting economic activity.”

However, in the above quote, he said the “direct effects” of lower profitability for insurance and pensions on the “entire economy may not be substantial”.  Nevertheless, he is watchful of effects on “people’s confidence”.

One might conclude from this discussion that Kuroda would like to persist with QQE policy with NIRP, and may further extend these measures, but will look for ways to mitigate the negative impact on bank and other financial institutions’ profits.  This might include adjusting the QE to lessen the flattening impact it has on the yield curve.

It might also include allowing banks to borrow at negative rates to the extent that they participate in the Bank’s various 12 month or longer term loan support programs.


No limits, but some things are off-limits

Kuroda said, “Needless to say, there is still ample space for further cuts in the negative interest rate and for an increase in size in the “quantity” dimension. The Bank has a broad range of policy options.”

Many market observers agree that there is scope to cut rates further (although there is a debate on whether this is a good idea).  However, most market observers do not agree that there is much room to expand the quantity of asset purchases.  In particular, most think the BoJ is running out of space to continue buying JGBs at its current pace.

Kuroda made it clear that “The basic mechanism of monetary policy, whether it is conventional or unconventional, is to drive the real interest rate higher or lower than the “natural rate of interest”.

In other words, while there are negative consequences of driving down yields, probably flattening the yield curve as the lower bound for interest rates is approached, the central bank has no other choice but to do so to achieve a goal of higher inflation.

He said, “It is often argued that there is a “limit” to monetary easing, but I do not share such a view.

Needless to say, there is a limit in the sense that there are things that “cannot be done legally” or “should not be done,” such as directly underwriting government bonds and monetizing fiscal deficits. As I said earlier, however, even within the current framework, there is ample room for further monetary easing in either of three dimensions — quantity, quality, and the interest rate — and other new ideas should not be off the table.”

In this paragraph, Kuroda suggests there is no intention to conduct so-called helicopter money policy, saying this is not legal and “should not be done”.

He continues to argue that there is “ample room” in the current framework, although most observers dispute this, seeing the bank already near the boundaries of the pace of asset purchases.

Kuroda may be ready to look at “other new ideas” but most that have been floated are of marginal influence.


Costs and Benefit framework

But while Kuroda sees few limits to his policy tools, the key point is that deciding how much they should be used and in what mix is a matter of comparing “benefits and costs”.

Kuroda notes that “additional monetary easing entails costs”.  But he said, “we should not hesitate to go ahead with it as long as it is necessary for Japan’s economy as a whole; namely, if its “benefits” outweigh its “costs.””

“Furthermore, what is important is that a balance between “benefits” and “costs” can change depending on the situation. Monetary policy should be conducted in a flexible manner. There may be a situation where drastic measures are warranted even though they could entail “costs””.

These thoughts generate questions – do the benefits currently outweigh the costs? Is the current policy mix appropriate or have the benefits and costs shifted such that the policy mix should be adjusted?  Does the current situation warrant drastic measures?

Kuroda goes some way to directly address these questions.  His final paragraph said, I would add that the “benefits” of achieving the price stability target of 2 percent at the earliest possible time are enormous as Japan’s economy is finally overcoming deflation that lasted for a prolonged period of time. The Bank will continue to make its utmost efforts to achieve this commitment.”

He says here that the benefits are “enormous” implying they indeed outweigh the costs. He suggests having made progress, the BoJ should not give up now.

However, from the overall tone of the speech (progress being made, near full employment, adaptive expectations likely to respond to stabilization in oil prices), drastic measures may not be warranted.


Exchange rate conspicuous in its absence

One notably absent feature of this speech is that it did not once mention the stronger JPY in the last year as a factor that has undermined inflation or the effectiveness of monetary policy.  One might conclude that the issue of the exchange rate is highly politically sensitive and consideration of buying foreign bonds as part of the policy mix is not being seriously considered.

There is no evidence that the BoJ has any desire to influence government intervention policy.  Significant direct action on the exchange rate appears still off the table and strength in the JPY remains a risk that could again significantly dampen the effectiveness of monetary policy.

A further cut in NIRP, especially in the context of the USA Federal Reserve getting close to a second rate hike this cycle, could contribute to a weaker JPY.  The JPY may now have worked off a good part of its over-sold condition in early 2015, and is less likely to rise much more.  Perhaps the benign neglect of the exchange rate will be less of a problem going forward.

However, the lack of consideration of the exchange rate is one element that may become a problem if it resumes its advance this year.  This could occur if global investor confidence wanes, global growth falters or the US again puts rate hikes on the back-burner.