Bank of Japan stands firm amid concern over side effects of easing

As expected, there were no changes to monetary policy from the Bank of Japan (BoJ) on Wednesday. The short-term policy rate was kept on hold at -0.1%, the 10-year government bond yield target kept at “around zero per cent” alongside an unchanged ¥80 trillion annual pace of Japanese government bond (JGB) purchases. Also kept the same was the forward guidance introduced in July, stipulating that current low rate policy would be maintained for “an extended period of time”.

The inflation outlook was revised down yet again across fiscal year (FY) 2018-2020 in the accompanying quarterly Outlook Report. Specifically, the forecast was revised down by 0.2% year on year, to 0.9% for FY2018 and to 1.4% and 1.5% in 2019* and 2020, respectively. The growth outlook was also slightly lowered for 2018 by 0.1% to 1.4%, but kept unchanged in 2019 and 2020. The risks around economic activity and prices were now noted to be skewed to the downside rather than roughly balanced.

The BoJ issued a slightly stronger warning on the impact of prolonged monetary easing on the financial system, adding that, “although risks are judged as not significant as this point, it is necessary to pay close attention to future developments”. This follows the recent Financial Stability Report that showed no cause for immediate concern for the financial system, but continued to highlight building downside risks, particularly over the next three years.

The takeaway from this BoJ meeting was that the central bank still have no grounds to tighten policy on an outlook for inflation that remains well below its 2% target. However, the central bank is clearly becoming more concerned about the side effects of prolonged monetary easing – namely, the functioning of the government bond market and the stability of the financial system. The change in yield curve control policy in July - to allow more flexibility in the 10-year government bond yield - reflected these concerns, which do not seem to have gone away. Our view is that, in a backdrop in which the Japanese administration is becoming more relaxed about the 2% inflation target, the BoJ reaction function is slowly changing from inflation to financial stability.

The rise in the consumption tax in October next year provides a narrow window for the BoJ to tweak policy again before the latter half of 2020, when the economy is expected to recover from the subsequent expected decline in demand. We see a risk that the BoJ allows the 10-year Japanese government bond yield to rise another 10 basis points due to concerns surrounding prolonged monetary easing.

 *excluding the consumption tax.