The Bank of Japan introduced a 10-year yield peg at around zero percent last September together with an existing negative short-term interest rate (minus 0.1 percent). This yield curve control was essentially opposite to Operation Twist used by the U.S. Federal Reserve. Notwithstanding the de facto tightening of monetary easing, the markets reacted to it positively with a shift toward short positions in the yen and long positions in stock prices.
Under the yield curve control, the BOJ officially abandoned the guideline for the average remaining maturity of Japanese government bond (JGB) purchases, which used to be in the target range of around seven to 12 years. This guideline had been intended to prioritize exerting downward pressure on longer-term bonds because of greater monetary accommodation generated through flattening the yield curve. Since the BOJ also announced its projection that an annual JGB purchase of around ¥80 trillion would be maintained, yield curve control has implied less JGBs purchases on longer-term yields and more JGBs purchases on shorter-term yields.
The yield curve control steepens the yield curve and is in contrast with the two Operation Twists adopted by the Federal Reserve to put downward pressure on long-term interest rates to stimulate the economy — one at the initiative of U.S. President John F. Kennedy in 1961 under the Bretton Woods System and another initiated under Fed Chairman Ben Bernanke in 2011-2012 under the Maturity Extension Program. The former was to purchase Treasury securities with maturities of five years or longer, while maintaining a short-term interest rate (thus interest differentials vis-a-vis higher-yielding Europe) to prevent an outflow of gold to Europe. The latter was to sell or redeem Treasury securities with remaining maturities of about three years or less and use the proceeds to buy Treasury securities with remaining maturities of six to 30 years.
Why was the yield curve control adopted despite it being de facto tightening? By pegging the 10-year yield at around zero percent, the BOJ appeared to have prevent longer-term JGB yields from falling excessively and prevented the yield curve from becoming too flat — phenomena that were amplified after adoption of the negative interest rate. This suggests that there are some thresholds below which a further cut in JGB yields (and lending rates) no longer generates much impact on credit demand, aggregate demand, inflation and inflation expectations. Instead, smaller lending-deposit interest rate spreads became a growing cause of concern for commercial banks in the absence of strong credit growth.
Low returns on JGBs also raised their concerns because of large holdings of JGBs to fill the gap between loans and deposits. Insurance firms and pension funds suffered from low returns on assets and higher liability due to a declined discount factor. If such policies continue for a long time, the financial instability risk may rise. Thus, yield curve control can be viewed as the BOJ’s admission of potential adverse effects.
Japan’s case highlights the dilemma between price stability and financial stability. Generally, central banks stress that monetary policy should prioritize price stability over financial instability risk — macroprudential policy should deal with financial instability risk, and monetary policy should be used as a second line of defense. But such a clear division of labor may no longer be possible. Central banks also may not be able to monitor liquidity risks adequately through market data (such as bid-ask spreads). This is because the overwhelming impact of monetary easing is likely to have induced market participants to react to the extraordinary market conditions by adjusting transaction volumes and thus mitigating market stress. Risks may suddenly materialize unexpectedly.
Although yield curve control dealt with some adverse effects, it generated new potential problems. If the 10-year yield is kept too long at a rate that can’t be justified from a credit risk perspective, the risk of undermining financial intermediation functions and delaying corporate sector restructuring may increase. JGB market distortion has become severe since price information is largely suppressed. Eventually the BOJ must choose between maintaining existing large-scale monetary accommodation for what’s likely to be a shorter time, or reducing the degree of monetary accommodation somewhat today and focusing on maintaining the new level of monetary accommodation for a longer time. The European Central Bank opted last December for the latter.
Since the U.S. presidential election, higher U.S. yields in anticipation of higher economic growth and inflation together with yield curve control helped to depreciate the yen vis-a-vis the dollar and Japanese stock prices. This suggests that the markets regard yield curve control as more effective than the negative interest rate policy. Nevertheless, its impact on domestic demand has not been strong and it is widely viewed in Japan that 2 percent inflation is unlikely achieved any time soon. Given that monetary policy is overstretched, it may be time for the BOJ to provide more reasonable projections about the time by which it can achieve 2 percent inflation and present a more sustainable monetary policy framework for this period.
Sayuri Shirai is a professor at Keio University, a former Policy Board member of the Bank of Japan and the author of “Mission Incomplete: Reflating Japan’s Economy.”
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