Look at me, look at me!
The market has brushed aside the latest apparent tinkering from the Bank of Japan, but if the fiscal authorities choose, this latest step could usher in a significant reflation.
The Bank of Japan (BoJ) must be wondering what it has to do to be noticed by the markets. Policy has become increasingly outrageous and yet seems to have had little impact. In my opinion, the latest changes are potentially radical, but it depends what happens next.
One popular narrative is that the switch to yield curve control is just an excuse to taper without making a formal announcement. The argument is that the BoJ will eventually run out of JGBs to buy (its balance sheet is expected to rise to 100% of GDP over the next year) and therefore has to slow down its rate of purchase. By promising to hold yields around zero on 10-yr JGBs, the BoJ might not need to make that many purchases to achieve the aim as the market knows the yield is effectively fixed.
The new commitment to overshoot its inflation target has also been largely dismissed. The logic runs that this lacks credibility since the BoJ can’t even get inflation up to 2%. However, these changes are potentially very powerful and make it easier for Japan to move down the spectrum towards helicopter money.
If fiscal policy were to become more expansionary (beyond the current plans), this would presumably put some upward pressure on yields. Under the previous regime, higher yields would have dampened the fiscal impact. But under the new regime the BoJ might have to increase its purchase rate to meet the yield target. This adds more stimulus as well as avoiding any crowding out.
In this environment the market might be even more inclined to challenge the yield target, further increasing the number of bonds the BoJ has to buy. In the extreme, the BoJ would potentially have to buy the entire stock of JGBs. The effect is amplified by the commitment to overshooting the inflation target.
Previously the BoJ would have been expected to back off as inflation started to rise towards target. This led to an asymmetry. Meeting the inflation target was vulnerable to any disinflationary shock (such as the fall in oil prices), but there was little danger of an overshoot. This knowledge has kept inflation expectations subdued and given support to the yen. Both have further undermined the BoJ’s attempt to raise actual inflation. Now it is more likely the BoJ keeps buying at a rapid pace, which could lead to a sharper rise in inflation expectations, greater downward pressure on the yen and ultimately higher inflation.
The fiscal authorities have the monetary framework in place to produce inflation if they choose. The challenge is calibrating the response, as the probability of lurching from deflation to hyperinflation has just increased, but they may finally get the attention that they're looking for.