Commentary / Japan

Bank of Japan's growing global challenges

by Sayuri Shirai

The U.S. Federal Reserve opened the year with a dovish turnaround in its monetary policy due to concerns over global economic growth and muted domestic inflation. It was done by signaling adherence to the status quo on policy interest rates, for the time being, as well as a willingness to stop the balance sheet runoff earlier than envisaged. The U.S. stock market welcomed the moves with higher share prices and a weaker dollar. It also gave emerging economies breathing room to pursue higher yields .

However, the shift in U.S. monetary policy has generated greater uncertainty over Japan’s exchange rate and financial markets. First, the yen has stabilized at around 109 to 110 against the dollar, somewhat below the comfortable 110 to 115 range which continued for over half a year until the rise in U.S. capital market volatility in late December.

In addition, the yen experienced a “flash crash” against the dollar on Jan. 3, appreciating nearly 4 percent to around 104 in less than 10 minutes. This speculative attack took place during the New Year’s holidays, when the foreign exchange market was shallow, and has kept Japan’s government on alert for another flash crash during the 10-day Golden Week holiday from late April.

Second, Japan’s long-term interest rate has re-entered negative territory this month, as the U.S. long-term interest rate has dropped to around 2.6 to 2.7 percent. This may reflect a return of some domestic investors from overseas portfolio investment and increased demand for foreign investors that shifted away from Japan’s stocks. The negative or substantially low long-term yield might be necessary to maintain sufficient U.S.-Japan interest rate differentials to contain the yen’s appreciation pressures. On the other hand, an excessively low yield threatens the financial sector, compelling the Bank of Japan to reduce the annual pace of Japanese Government Bond purchases at a level that can mitigate the above conflicting forces.

These market developments are a reminder that the yen remains a safe-haven currency against the dollar and other currencies. Growing concerns over global economic growth and the tense U.S.-China relationship could add to the yen’s appreciation pressures. It is also clear that the dollar-yen rate not only depends on Japan’s monetary easing but also U.S. market conditions such as higher stock prices and dollar strength.

So far, Japan’s government has coped with sharp yen appreciations by holding tri-party talks among the Finance Ministry, Financial Services Agency and BOJ, signaling possible intervention in the foreign exchange market to contain market pressures. The Finance Ministry has not intervened in the foreign exchange market since 2011 thanks to massive monetary easing doing the job effectively. Nonetheless, the government wishes to maintain foreign exchange intervention as an alternative tool in case monetary policy no longer works.

In this sense, the upcoming trade negotiations between Japan and the United States could be of great consequence to Japan. A trade deal that includes a foreign exchange clause requiring a commitment to market-determined exchange rates, like the new United States-Mexico-Canada Agreement, could deter Japan from engaging in foreign exchange intervention and thus render its tri-party talks virtually ineffective.

Third, Japan’s stock prices have so far this year underperformed relative to those in the U.S. This mainly reflects an increase in downward revisions of manufacturing corporate profits for fiscal 2018, rarely seen over the past two years and fueled by China’s economic slowdown rather than the current yen exchange rate. Foreign investors’ reduced appetite for Japan’s stocks has further undermined share prices.

In light of these developments, foreign investors are increasingly interested in seeing what additional actions the BOJ could take during the next recession or in case of a persistent appreciation trend over the yen. The most likely response by the central bank is to maintain the current monetary easing framework given that almost all mitigation tools have been used up.

The bank, meanwhile, may expand the target range on the 10-year yield from plus/minus 0.2 percent to plus/minus 0.3 percent, thereby allowing a temporary decline in the yield. This is preferable to lowering the 10-year policy rate since it contains an element that might support normalization in the future. In addition, the exchange-traded fund purchase program can be operated more flexibly, for example, by increasing the annual pace of ETF purchases to more than ¥7 trillion from the current roughly ¥6 trillion if necessary and reducing it to well below ¥5 trillion in other times.

However, these adjustments, if maintained too long, would only end up amplifying the dilemma by intensifying stress in the financial sector and/or undermining the bank’s balance sheet. In any case, it will no doubt be a very long time before the bank takes any clear steps toward normalization.

Sayuri Shirai is a professor of Keio University, a visiting scholar to ADB Institute and former Bank of Japan Policy Board member.