Bank of Japan loosens yield curve control, pledging ‘greater flexibility'

• The Bank of Japan will now offer to purchase 10-year JGBs at 1% through fixed-rate operations, effectively raising its tolerance by 50 basis points.
• BOJ Governor Ueda says this is not a precursor towards policy normalization, but merely represents a tweak to ensure the sustainability of its yield curve control.
• Short-term interest rate was kept at -0.1%, while the median inflation forecast for 2023 was upgraded to 2.5% from 1.8% previously. Median 2024 inflation forecast was downgraded to 1.9% from 2% previously.

Japan's central bank on Friday loosened its yield curve control, underscoring concerns about its protracted monetary easing on financial markets and the real economy.

In a policy statement, the Bank of Japan said it will continue to allow 10-year Japanese government bond yields to fluctuate in the range of around plus and minus 0.5 percentage points from its 0% target level — though it will offer to purchase 10-year JGBs at 1% through fixed-rate operations. This move effectively expands its tolerance by a further 50 basis points.

The BOJ pledged to "conduct yield curve control with greater flexibility, regarding the upper and lower bounds of the range as references, not as rigid limits, in its market operations," citing the need to remain nimble given "extremely high uncertainties for Japan's economic activity and prices."

In what was BOJ Governor Kazuo Ueda's first major policy change since he took the helm in April, the central bank also kept its ultra-loose interest rate intact, electing to hold its short-term interest rate target at -0.1% after its July policy meeting. It also raised its median forecast for inflation to 2.5% for fiscal 2023, up from its 1.8% prediction in April.

"This is not intended as a step toward policy normalization. Rather, it's a step aimed at enhancing the sustainability of YCC," Ueda said at a press conference in Tokyo on Friday afternoon explaining the central bank's decision, according to a translation provided by Reuters.

"Responding after upward risks materialize would put us behind the curve, and make the side-effects very large. The risk of us being forced to abandon YCC against our will is not zero. That's why we need to act pre-emptively," he added.

Market reaction

Years of accommodative monetary policy in Japan — even as other global central banks have tightened policy in the last 12 months — have concentrated carry trades in the Japanese yen. Carry trades involve borrowing at a lower interest rate to invest in other assets that promise higher returns.

Yields for the 10-year JGB touched their highest since September 2014 as the BOJ announcement triggered a sell-off, while the yen whipsawed against the dollar.

The benchmark Nikkei and Topix stock indexes — standout outperformers in the Asia Pacific in the last 12 months — deepened losses after the announcement, but recovered before the close. Japanese bank shares rallied in Tokyo, with Mitsubishi UFJ surging 5.3% to its highest in more than 4½ years.

U.S. Treasury yields spiked after an earlier Nikkei report suggested the BOJ will allow "long-term interest rates to rise beyond its cap of 0.5% by a certain degree."

"In practical terms, this 'flexibility' language is similar to that used in late 2022, when the 10yr JGB target range was increased from +/-25bp to +/-50bp," said Stephen Halmarick, Commonwealth Bank of Australia's chief economist in a note. "The 'flexibility' does represent, therefore, some tightening in monetary policy."

Still doves, not hawks

Ueda, however, pushed back on such suggestions, saying Friday's announcement represents a modification of the central bank's current dovish position.

"The bond market is pretty stable now and we saw uncertainty over the outlook very high. This was a good timing to make tweaks to our policy framework," Ueda said at the same press conference.

"If inflation expectations heighten and we try to control bond yields with our market operation, real interest rates will fall. That would stimulate the economy and prop up inflation. We've seen such effects appear on the economy in the past year or so," he added.

"On the other hand, that also means the side-effects are increasing. We looked at the balance of both factors, and decided to make YCC flexible," Ueda said.

With the spike in commodity prices last year, the BOJ was forced to defend its yield limit with more bond purchases. This led to accusations the central bank was distorting the pricing mechanism in the market, which led to yen weakness that in turn inflated the cost of raw materials imports even further.

Consequently, the BOJ has been under pressure to tighten its monetary policy. Inflation has consistently exceeding its 2% target for 15 straight months, while wages are finally starting to increase after years of stagnation.

"Sustainable and stable achievement of the price stability target of 2%, accompanied by wage increases, has not yet come in sight, and thus the Bank needs to patiently continue with monetary easing under Quantitative and Qualitative monetary easing with yield curve control," the BOJ said Friday.

Economists have been watching for more changes to the BOJ's yield curve control policy, part of the Japanese central bank's efforts to reflate growth in the world's third-largest economy and sustainably achieve its 2% inflation target after years of deflation.

The BOJ, however, disagrees.

"Letting yields move completely freely would essentially be abandoning YCC, and we're not ready for that," Ueda said. "We'd like to adjust the speed of yield moves and prevent speculative bond trading from spreading."

Forward guidance

In the BOJ's quarterly outlook, the bank said it expects the Japanese economy to grow above its projected potential, given the virtuous cycle that is emerging from higher income that has partly led to an improvement in consumer sentiment and consequently, increased spending.

The central bank also said "signs of change have been seen in firms' wage- and price-setting behavior."

The BOJ expects further upward pressure on wages to come from Japan's output gap, which could potentially turn positive around mid-fiscal 2023 before growing at a moderately slower pace after. It would increase consumers' purchasing power in the process.

Output gap refers to the difference between an economy's actual output and its potential output at full capacity.

While the BOJ governor admitted Friday the central bank has been underestimated upward price pressures, BOJ has also previously said inflation will slow toward the end of this year.

On Friday, the BOJ downgraded its inflation median forecast for 2024 to 1.9% from 2% previously, and retained its 2025 forecast for 1.6%.

"It still seems likely that inflation will slow over the coming months as lower import prices weigh on goods inflation, which has accounted for the bulk of the recent acceleration in underlying inflation," Marcel Thieliant, head of Asia-Pacific at Capital Economics, said in a note.

"If the economy enters a recession in the second half of the year as we anticipate, the case for policy tightening will diminish," he added.