What is the Bank of Japan doing?

This week the Bank of Japan (BOJ) continued its struggle with managing that infamous monetary policy instrument known as Yield Curve Control (YCC). Under pressure from markets to abandon the policy, or at least raise the target range, the BOJ announced that it would set a “reference” rate (code for target) for the yield on 10-year Japanese bonds of 1%, the current upper bound of the YCC target range, in an attempt to keep Japanese interest rates from rising too sharply.

The problem for the BOJ is when the market begins to think the YCC policy is unsustainable. This is what is currently happening in Japan where inflation remains high and sticky, and investors are selling bonds to avoid capital losses in anticipation the pressure from high inflation rates will force the BOJ to abandon YCC.

Consequently, to keep the interest rate at its target, the BOJ must step in and buy bonds. But here’s the rub, by buying bonds, the BoJ injects Yen into the system, placing downward pressure on the currency.

But the market wasn’t buying the BOJ move, with the Yen falling to a new low. So, will the BOJ, like the RBA, be forced to abandon YCC?

Unfortunately for the BOJ, the Japanese economy finds itself in quite a tricky place. The Japanese economy has experienced stellar growth over the first half of the year, even outperforming the gangbusting US economy.

But unlike the US, Japanese inflation has been falling only gradually; a mere 0.4 percentage points (ppts) from 3.6% to 3.2%. In contrast, US inflation has fallen by over 2ppts since the start of the year; albeit from a higher starting point.

Given this stickiness in inflation, why is the BOJ reluctant to allow rates to rise? The answer is the BOJ’s need to take advantage of the high post-Covid rates of inflation to turnaround the entrenched low inflation expectations that have plagued the Japanese economy for the better part of three decades, and it can’t achieve this if it tightens monetary policy prematurely.

But can the BoJ sit on a rate fix of 1% if the market continues to sell the Yen? No, it can’t and the Yen above ¥150 (per USD) seems to be a line in the sand.

And just like the RBA, the situation is not entirely in the BOJ’s hands. A lot will depend on where the US Federal Reserve (Fed) and other central banks take their interest rates.

If the Fed and other major central banks are now at the top of their tightening cycles, as seems likely, then this will give the BOJ (and the RBA for that matter) some breathing space by taking pressure off the Yen and allow them to keep the YCC at 1%. If not, the Yen will come under pressure and the BOJ will be forced to react, either by increasing the YCC target rate or abandoning the policy altogether, as was the case with the RBA.

Finally, next week we have the RBA meeting on what often proves to be an important pivot-point Cup Day meeting. We retain our view that the RBA will raise the cash rate to 4.35% which should prove the last rate hike of this historic tightening cycle.