The BOJ Normalizes, Not By Stealth But By Guile

by: Adam Whitehead

The BOJ’s normalisation process is ahead of its developed central bank peers hence it is closer to easing again than they are.

The BOJ is now focused upon the creation of a small conventional interest rate cushion at some point on the yield curve.

Some former BOJ Monetary Policy Board members may be guiding towards normalisation on behalf of the BOJ.

The risk of the BOJ being “price-discovered” for not doing what it says it is doing is rising.

The “price-discovery” of conflicting BOJ guidance and action may be something that Governor Kuroda is prepared for.

Despite all the criticism, for missing its inflation target, the BOJ deserves credit for normalising without explicitly tightening monetary policy. If this normalisation is then followed by a further easing of monetary policy, which is not met with criticism, further kudos should be awarded to the BOJ.

Net purchases of JGB’s by the BOJ have been declining since 2016. Overlaying this clear evidence of a normalisation process, there has been guidance to suggest that the central bank is still committed to achieving its 2% inflation target through the unconventional policy tool of QQE. The headline story is that the BOJ has been normalising, when it says that it is still easing. The corollary backstory is that this means that the BOJ may be closer to the next phase of monetary policy expansion than its developed peers. In a world where trade wars threaten economic growth, the BOJ may be more in synchrony with this underlying theme than its normalising peer group.

What the BOJ lacks, however, is some kind of conventional monetary policy cushion that will inform the markets that it has the intentions and capabilities to address an economic slowdown in the future. It is this feature that the BOJ now seems intent upon creating. Such a positive interest rate cushion need not be large, or extend across the whole term structure of the yield, since the consensus amongst global observers is that we are in a structurally low interest rate environment. This cushion would be largely symbolic and indicative of normalisation mission completed. Its appearance would take many observers by surprise. Such surprise is, however, the hallmark of Governor Kuroda.

In practice, therefore, the BOJ has mitigated a steep appreciation of the Yen by obfuscating its stealth taper with guidance that promises to continue with QQE. Economic momentum has thus been sustained, extending what the BOJ has called the “virtuous circle”. Ultimately, the BOJ may deliver on this promise to continue with QQE. In practice, however, the commitment has been punctuated by a normalisation that has largely gone un-discounted by capital markets.

As the various sectors in the economy, that have been hurt by ZIRP/NIRP, have been increasing their demands for support the BOJ has been providing them with sustainable economic growth that can be maintained alongside slightly higher interest rates. This economic momentum itself means that the size of the conventional interest rate cushion, to deal with the next slowdown, need not be a large one.

If the BOJ is truly normalising, then this must be the stealthiest and best executed normalisation of any developed central bank so far.

The BOJ recently introduced a further element of ambiguity, into perceptions of its policy going forward, at its last Monetary Policy Board meeting. Whilst introducing guidance to reinforce the view that it is committed to monetary policy easing over the long term, in order to hit its elusive 2% inflation target, it also introduced some incremental changes to its current policy which could be construed as “stealth normalisation”. The last report suggested that this ambiguity would lead to the market testing the credibility of the BOJ’s commitment, thereby challenging the time consistency of its policy.

It is now becoming clear that, in addition to challenging the BOJ’s commitment, commentators will also try to re-frame perceptions of the BOJ’s ambiguity. Much of this commentary has been initiated by former BOJ policymakers, which gives it greater perspective and significance. It also suggests that they may have been primed to opine as part of an indirect guidance process.

Former BOJ policymaker Kazuo Momma provided an example of this Hawkish re-framing exercise. According to him, the BOJ should immediately drop its negative interest rate policy and capping of long dated bond yields. Momma envisions a situation in which the next economic slowdown comes, whilst the BOJ is still adhering to its long-term commitment to hit its inflation target. He therefore wishes to create some kind of conventional monetary policy cushion, from where the BOJ can then go through the monetary policy easing gears to arrive at more QQE again.

Former BOJ policymaker Hideo Hiyakawa discerns a “ stealth” tightening (note not Tapering), under construction from the BOJ’s recent change of stance to a rising interest rate corridor on long term yields.

Former policy board member Sayuri Shirai focused market attention on these recent changes; and stated unequivocally that this represents a transition towards normalising. She believes that this will begin in the second half of this year. Since we are starting Q3, this must occur soon. Anticipating the Yen strength that will accompany this policy move, she forecast new fair value against the US Dollar in the 100 to 105 range.

Former policy board member Koji Ishida “guided” that the BOJ may begin the normalisation, well before the inflation target is achieved, because the momentum in the economy is strong enough.

Japan’s regional banks recently reported profits down 30% year on year, signalling that the pain of negative interest rates is significant for them. Yield curve targeting by the BOJ evidently is not supporting them. The BOJ must, therefore, come up with targeted measures for them, or they must adapt. The head of the Financial Services Agency Toshihide Endo signalled that he does not expect the BOJ to do anything more to help them. This implies that they must adapt their business models and/or scale up through mergers and acquisitions. This view implies that any normalisation will be incremental; so that interest rates will not rise enough to significantly improve banking margins. It also implies the threat that these narrow margins will come under pressure swiftly as monetary policy is eased again.

In response to, or perhaps in co-ordination with, Hawkish former BOJ Monetary Policy Board member guidance the BOJ took a more neutral tone. Monetary Policy Board member Hitoshi Suzuki opined that the new BOJ positioning is not a tightening of monetary policy per se. Neither is it a direct form of support by subsidy of commercial bank margins.

Mr. Suzuki framed the latest BOJ moves as a tactic allowing the central bank to continue to investigate the trade-offs of continued monetary policy expansion. The BOJ is therefore not tapering, it is simply evaluating. Despite this verbal obfuscation, however, the BOJ continues to cut back its long-dated JGB purchases. The only thing that is certain, is the contradiction between the BOJ’s words and its actions.

(Source: Seeking Alpha)

The last report used the theme of the “Prisoner’s Dilemma”, to map out scenarios facing the BOJ. Applying this rubric, one may conclude that the BOJ is acting dishonestly. Thus far Mr Market has been acting honestly, in believing that the BOJ is sincerely committed, to hitting its inflation target, despite the recent tweaks to its QQE strategy. This is good for the BOJ and not good for Mr Market.

Unfortunately for the BOJ, the probability that we may be switching into the quadrant where Mr Market acts dishonestly is rising. Former BOJ Board member Kunio Okina has also noted this potential transition recently, with a thinly veiled warning to both Mr Market and the BOJ.

According to Mr. Okina, the risk that Mr Market does not accept the latest BOJ policy tweaks as being consistent with its guidance to strengthen its commitment to achieving its inflation target is rising. In effect, Mr Market observes that the BOJ is no longer doing what it says. Mr Market may then note that in fact the BOJ has been tapering since 2016. The BOJ will then in effect be busted, as the centrality of its time commitment to hitting its inflation target will be exposed as a sham. At this point some violent strengthening of the Yen and a sell-off in Japanese risk assets may occur.

This author believes that it is inconceivable that Governor Kuroda has not been expecting this day of reckoning however. All that he has been doing since 2016 is riding out his luck behind misleading yet self-effacing guidance. The violent market reaction to being found out will thus be used by him as an excuse to unilaterally ease again. After all, this violent market reaction may deliver him the required market signal and justification to do so.

If this market event is triggered by President Trump, Mr. Kuroda will also be able to slip away in the chaos without being blamed for causing it by lying. Jean-Claude Trichet was rightly blamed for the chaos, that led to further QE from the ECB, when he noisily and prematurely normalised. Kuroda has learned from this mistake. He can thus still opine his centrality of commitment to achieving his inflation target once again. Any appearance of failing in this commitment can once again be attributed to President Trump.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.