Wednesday's monetary policy meeting of the BOJ is being keenly anticipated by financial markets, mainly because the yen (NYSEARCA: FXY) continues to defy the central bank's loose monetary policy stance. Although the currency has edged slightly lower since we wrote about our contrarian view on the yen, it remains way higher than the lows seen mid last year.
We have argued before that a weaker yen is not the overarching goal of the BOJ's monetary policy. What matters most to Kuroda and his team is to drive down real interest rates across the curve . However, if the yen continues to strengthen, it does present the BOJ with a problem that needs to be dealt with. In this article, we look at the policy options that the Japanese central bank can use to arrest the currency's rise.
1. Targeting a level of nominal GDP (NGDP)
Of all the options in front of the BOJ, this is the most unconventional and perhaps the most unconvincing to monetary policymakers, but is gaining in popularity in the realm of monetary speculation. The central bank can explicitly state that it will continue to ease until Japan's NGDP reaches a specified level. The BOJ's current policy states that it will continue to purchase assets at an annual pace of 80 trillion yen and will continue to push interest rates deeper into negative territory. It does not mention until when this policy will be in force. Instead, targeting a precise level of NGDP may make monetary policy transmission more effective. Economic agents can be better persuaded to believe that the central bank will keep inflating until the goal is attained. This can also prove more decisive in lifting inflationary expectations, helping Japan reach the NGDP target faster. In other words, a virtuous cycle of economic growth and inflation can be set in motion through this policy. A key feature of targeting a level of NGDP is that it makes monetary policy indifferent to both real GDP and inflation. Therefore, it also does away with the need to have an inflation target. It doesn't matter how the NGDP level is attained, so long as it is attained. Having said that, targeting NGDP is still far from gaining majority acceptance in the central banking community. Therefore, despite its obvious attractiveness, it is rather unlikely that the BOJ will adopt this policy in this meeting.
2. Cutting deposit rates further
if the BOJ chooses to act this week, cutting deposit rates will be the most likely policy move. Although deposit rates are already in negative territory, there is no reason why they can't be lowered further. A seemingly obvious problem with lowering the deposit rate further is that it is going to hurt the profitability of Japanese banks. However, it the BOJ is charging negative deposit rates to banks' excess reserves in a staggered manner to ensure minimal impact on banks' profitability. If it chooses to cut deposit rates further, then the BOJ can always increase the thresholds for excess reserves on which negative rates would apply. For a better understanding of how negative rates are applied on banks' excess reserves, please read our previous article.
3. Adding other asset classes to the buying list
With the BOJ buying 80 trillion yen worth of Japanese government bonds annually, the stock of JGBs (NYSEARCA: JGBS-OLD, JGBD) available for buying is depleting fast. This bond buying spree is also creating problems for the smooth functioning of Japan's financial system, including balance sheet management issues for banks and insurance companies. Therefore, the market will want to see what other securities the BOJ might buy in order to maintain the pace of its balance sheet expansion. Apart from JGBs, the central bank is already buying ETFs, commercial papers and corporate bonds worth 3.3 trillion yen, 2.2 trillion yen and 3.2 trillion yen respectively every year. An increase in purchases of these securities is likely. However, the bigger question in everyone's minds is will the BOJ buy Japanese equities? Maybe, we will have an answer this week. Maybe we won't.
4. Expanding the pace of asset purchases
While this is no doubt an option for the BOJ, we don't think it's a particularly good one. Increasing the value of JGB purchases further is very difficult for the reasons mentioned above. Secondly, in the wake of yen's strength, it will be clear that the BOJ is trying to fight the currency's rise. This can create a negative feedback for the yen and push it higher still.
5. Doing nothing
While doing nothing will disappoint the markets, it is still very much an option for the BOJ in this week's meeting. The bank's MPC may well believe that no change in policy stance, coupled with some strong rhetoric in favor of yen weakness (in the lines of Mario Draghi's "whatever it takes" comment) will do the trick for now. Here the central bank will have the advantage of watching the Fed's move on the 26th before its own. However, the flip side of doing nothing is it can be interpreted by financial markets as lack of effectiveness of BOJ's monetary policy. So, communication will be the key in case the MPC chooses to make no changes to its current policy.
Given the tricky nature of Wednesday's meeting, no doubt then that it is being eyed so keenly and with considerable nervousness.
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