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Nobody does QE like the BOJ. For me this is a race not between the BOJ and inflation but between the BOJ and the global bust that will trigger a massive JPY bid. Pantheon with the note.
The BoJ stuck to its guns on Friday, making no changes to policy, and claiming that no changes were even being contemplated. Policy remains focused on the challenges facing the real economy, rather than financial variables, and Governor Kuroda warned that a tightening of policy risked an economic contraction. There is little prospect of a change in policy this year. Speculation had built ahead of the meeting that a change might be afoot. Yen weakness has been pronounced in recent months, prompting a joint statement by the MoF and BoJ. A key driver of yen weakness has been the widening yield differential between Japan and the rest of the world, particularly the U.S. Following a spate of hikes—some larger than expected—by other major central banks, some market participants had started to bet that the BoJ would capitulate on yield curve control, and widen the band.
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The BoJ has made some modest concessions in the impact of a weaker currency lately. The recent rapid weakness of the yen is seen as a negative, even if a weaker yen is still a net positive for the economy. The bank’s statement acknowledged the need to watch the impact of the yen on the economy and prices, without committing to any action, just yet. Governor Kuroda said, more than once, that monetary policy aimed to stabilise prices, not currencies.
We think FX intervention—if and when it arrives—will focus primarily on limiting volatility, rather than trying to put a floor under the yen. Japanese policymakers, Mr. Kuroda included, have stuck to the line that yen valuation should reflect economic fundamentals—including yield and growth differentials—and for now, it is the rapid movement of the yen, not the weakness of the yen itself, that does not reflect fundamentals. This sounds as though policymakers are more minded to tackle the rapid movement than the currency weakness.
If volatility is the main concern, tweaks to yield curve control are not the answer; they would, if anything, only add to the whipsaws experienced by the yen. Questions were raised at Friday’s Q&A as to whether the programme was nearing its limit, given JGB futures have at times broken through the 0.25% cap in illiquid trading hours, but the governor insisted this was not the case. It is worth noting that the BoJ’s purchase program saw no takers on Friday, suggesting the immediate pressure has fallen away. Mr. Kuroda said there had been no change in thinking about YCC, and that no policy review was necessary, rebutting as firmly as possible the idea that a change is imminent.
The trade-off from a change to YCC is an unattractive one for the BoJ. A large rise in 10-year yields risks materially tightening domestic financial conditions, in an economy not yet back to trend. A smaller rise might be less damaging, but would barely dent the yield differential relative to the U.S.
The tweak might have more power as a symbolic gesture, persuading markets that Japan’s authorities stood ready to defend the yen, particularly if paired with direct FX intervention. But markets are forward looking. Just as FX reserves are clearly finite, so is the BoJ’s ability to widen the YCC band.
Consequently, after the relief from a one-off narrowing of the rates differential, markets would likely begin to test the yen again. At best, the authorities would buy a little breathing space, but without a change in market perceptions of U.S. policy, this would be only temporary. In brief, the yen is set to weaken from here whatever the BoJ does, unless things change in the U.S.
Focusing on the fundamentals
We should remember that Japan faces very different inflation dynamics to the rest of the world. CPI inflation may be above target, but at 2.5%, it is still miles away from the problem it has become in other developed markets. The big increase in inflation in April was driven by base effects, and while food and energy prices are on the rise, underlying inflation is still soft.
The BoJ expects headline CPI to rise only moderately, thanks to a recovering economy, raw material costs, inflation expectations, and wage inflation, while CPI ex-fresh food is to remain around 2% for some time, but ultimately to decline as the contribution of energy prices fades. Our own forecast currently sees inflation beginning to cool as soon as Q3, though we may need to revise it slightly higher to incorporate the persistent weakness of the yen.
Either way, there is no case here to tighten policy.
Even if inflation surprises materially to the upside thanks to the yen move, Governor Kuroda reiterated the importance of seeing wage growth alongside rising prices. Without higher wages, any inflationary increase should prove unsustainable, and selfcorrecting. Fortunately for the BoJ, they have more room than other central banks to put this to the test.