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“Mission incomplete” aptly describes the lack of progress made by the Bank of Japan in reflating Japan’s moribund economy. In April 2013, under its new governor Haruhiko Kuroda, the BOJ launched its unprecedented quantitative and qualitative monetary easing (QQE) policy to overcome chronic mild deflation. He was confident that the 2 percent price stability target would be achieved in two years.

Four years later, underlying inflation remains around zero percent and is lower than that in the euro area (about 1 percent). Thus, the BOJ lags behind the European Central Bank (ECB), which conducts similar unconventional monetary easing. Japan’s inflation is projected to rise in 2017 mainly due to weakened impact of an oil price drop. But it is widely expected that the BOJ will not achieve 2 percent inflation anytime soon in contrast to the BOJ’ current projected timing (around fiscal year 2018).

The QQE policy targeted the monetary base through massive purchases of Japanese government bonds (JGBs), exchange-traded funds and Japanese real estate investment trusts. With the annual pace of JGB purchases of around ¥80 trillion ($700 billion), the BOJ’s total assets swelled to about 90 percent of gross domestic product. The BOJ added a negative interest rate in January 2016 and yield curve control last September.

Thanks to massive unconventional monetary easing, overvaluation of the yen and undervaluation of stock prices were corrected. And yet, real consumption dropped slightly between the first quarter of 2013 (prior to the adoption of QQE) and the fourth quarter of 2016, while prices rose by 2 percent mainly due to a consumption tax hike and the yen’s depreciation. Industrial production and export volume remained largely constant while real exports rose by about 10 percent due to a shift toward higher-value-added goods.

Why is a negative interest rate not workable in Japan? First, a negative interest rate is not fully consistent with massive JGB purchases. Commercial banks dominate the financial system and hold JGBs substantially to fill the gap between retail deposits and loans for many years. They need to decide whether their JGBs should be sold to the BOJ and earn interest from the current account or, alternatively, held until maturity to earn the coupon rate. The positive rate provided an incentive for selling to the BOJ while the negative rate did the opposite. Liquidity and functioning of the JGB markets have thus further deteriorated. This situation is very different from that in the euro area where over half of sovereign bonds are owned by nonresidents in many countries. In Japan, only 6 percent of sovereign bonds are owned by nonresidents.

Second, notes in circulation as a share of GDP grew rapidly after the interest rate turned negative because many retail depositors converted deposits into cash to be kept in home safety boxes (year-on-year growth of notes in circulation exceeded 5 percent until the fall of 2016 while growth of individual deposits dropped from over 2 percent in 2015 to around 1 percent in 2016). Notes in circulation hit nearly 20 percent of GDP in 2016 as households faced a rock-bottom retail deposit rate — this ratio is high compared with the euro area (around 10 percent). Retail deposits and cash are also three times larger than household loans: the negative interest rate appears to have made households gloomy about the future.

Third, the negative interest rate with low credit growth squeezed the lending-deposit spread and reduced banking profits. The loan-deposit ratio has been below 70 percent in Japan — lower than the euro area (around 110 percent). Commercial banks have suffered limited profitability from maturity transformation since the yield curve flattened substantially. Institutional investors have been faced with low returns and higher liability due to a low discount rate; some insurance companies have stopped providing savings-type insurance plans due to limited returns or raised premiums for new clients.

The BOJ, therefore, corrected some adverse impacts of the negative interest rate last September by fixing the 10-year yield at around zero percent and moderately steepening the yield curve. This framework contributed to a depreciation of the yen and a rise in stock prices after the U.S. presidential elections.

But ambiguity over the BOJ’s commitment to a 10-year yield peg has confused the markets and generated volatile yields. This reflects the BOJ’s apparent reluctance to increase the total amount of JGB purchases and fixed-rate purchase operations when interest rates are under upward pressure. With persistent upward pressure, the BOJ might end up purchasing more JGBs than in the past, even though it abandoned monetary base targeting. The BOJ’s commitment is likely to be tested in 2017 as stronger upward pressure is likely to re-emerge.

What will be the BOJ’s next move in 2017? Given that sustainably achieving 2 percent inflation is a distant prospect, it may be time for the BOJ to present more realistic projections about inflation and make the monetary easing framework more sustainable so that adequate monetary accommodation can be maintained for a longer period.

One possibility is raising the 10-year yield target level to around 0.5 percent or introducing a target range of around zero percent to 0.5 percent as a first step. This could accompany a gradual cut in the annual pace of JGB purchase toward net issuance of JGBs (around ¥50 trillion). The ECB already decided to take this direction last December to make it more sustainable.

Sayuri Shirai is a professor of economics at Keio University, a former BOJ board member and the author of “Mission Incomplete: Reflating Japan’s Economy.”

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