The Bank of Japan (BOJ) is facing growing calls to accelerate its exit from its yield curve control (YCC) policy, which has been suppressing long-term interest rates for years, as inflation and currency pressures mount.
The YCC policy, introduced in 2016, aims to keep the 10-year government bond (JGB) yield around zero percent by adjusting the amount and frequency of bond purchases by the BOJ. The policy is intended to stimulate the economy and achieve the BOJ’s elusive 2% inflation target.
However, the policy has come under scrutiny as inflation has risen above 2% in recent months, driven by higher commodity prices and supply chain disruptions. The BOJ’s latest quarterly outlook report, released on Friday, showed that the core consumer price index (CPI), which excludes fresh food, is expected to average 2.8% in fiscal 2023 and 2.1% in fiscal 2024.
Some analysts argue that the BOJ should allow the 10-year JGB yield to rise further to reflect the inflation dynamics and ease the pressure on the financial sector, which has suffered from low profitability and reduced lending margins under the negative interest rate regime.
According to a Bloomberg report1, Mohamed El-Erian, a former chief executive officer of Pimco and a Bloomberg Opinion columnist, urged the BOJ to hasten its exit from YCC or risk unsettling instability in the bond markets in Japan and abroad. He warned that the longer the BOJ maintains its ultra-easy policy stance, the greater the probability that traders will test its resolve and push the 10-year JGB yield toward 1%.
Another challenge for the BOJ is the weakening of the yen against the US dollar, which has breached the 150 level several times in recent weeks. The depreciation of the yen is partly driven by the widening interest rate gap between Japan and the US, where the Federal Reserve has signaled that it will start tapering its bond-buying program soon and raise interest rates next year.
The weak yen poses a dilemma for the BOJ, as it could boost exports and inflation, but also erode consumer purchasing power and trigger currency intervention by the government. The BOJ has cited currency volatility as one of the factors behind its decision in July to widen the band for the 10-year JGB yield from 25 basis points to 50 basis points around zero percent.
However, some market participants expect the BOJ to further tweak its YCC policy at its two-day meeting starting on Monday, as reported by Nikkei. The BOJ may consider allowing the 10-year JGB yield to move beyond its current cap of 0.5% by a certain degree, according to the report.
The BOJ has several options to adjust its YCC policy, such as raising or lowering the target level, changing or removing the cap, or introducing a range or a slope for the yield curve. However, any policy change would have to balance the trade-offs between supporting growth and inflation, maintaining financial stability, and preserving market functioning.
The BOJ may also face communication challenges in explaining its policy rationale and signaling its future intentions to avoid confusing or surprising the markets. Governor Kazuo Ueda, who is due to step down in April after a decade in office, may have to navigate a delicate transition period as he prepares to hand over the helm to his successor.