MC Explains: What does BoJ’s tweak in yield curve control policy mean?

Bank of Japan logo on a smartphone screen and Bitcoin, Ethereum, Litecoin and Dogecoin cryptocurrencies logos in the background. (Photo Illustration via Getty Images)

The last bastion of ultra-accommodative monetary policy seems to have fallen. In an unexpected move, the Bank of Japan (BoJ) announced that it would allow government bonds to move in a wider band under its Yield Curve Control (YCC) policy, a signal the market is interpreting as the first step towards normalization.

On Tuesday, the BoJ said it would allow fluctuations of the yield on the 10-year benchmark Japanese government bond (JGB) in a wider range of +/- 0.50 percent instead of the current +/- 0.25 percent. The BoJ will continue to buy an unlimited amount of JGBs to keep the yield near zero, it reiterated in a statement.

While the contours of the monetary policy statement are largely unchanged, the change in the yield cap has triggered expectations that the BoJ may well have begun to normalize policy. Note that BoJ has been the outlier among central banks so far. We explain what it means for the markets.

Under the policy the BoJ introduced in September 2016, the central bank can buy an unlimited amount of government bonds from the market to keep yields within the band it wants. The yield curve control policy has enabled Japan to keep yields ultra-low, at times even in negative territory, to counter deflationary forces in the economy.

With the risk-free rate near zero and even negative, all interest rates in the economy have trended towards that end. The BoJ is mandated to keep inflation at a targeted 2 percent. Japan’s economy has been in the throes of deflation for more than a decade now.

Low yields are required to stimulate investments and even consumption as companies and citizens are incentivized to spend. The YCC, however, has given mixed results as, despite massive buying by the BoJ, Japan’s economy has not been able to shrug off deflationary forces successfully. The impact of the COVID-19 pandemic has also queered the pitch for the central bank.

The BoJ has tweaked its YCC policy to allow for the 10-year JGB yield to rise to 0.50 percent from the current 0.25 percent. This has been interpreted by economists as a decisive shift towards normalization of monetary policy. This means that Japan is now tolerant of slightly higher risk-free rates.

By extension, interest rates elsewhere can also rise. Therefore, bond yields across the world have got an extra fillip from the BoJ’s change. Note that the BoJ can still buy an unlimited number of bonds. In fact, the central bank has vowed to increase its purchase of JGBs in the coming months, keeping its monetary policy ultra-loose. It will now buy 9 trillion yen worth of bonds every month, up from 7.3 trillion yen so far.

The BoJ’s bond purchases under the YCC policy have resulted in a structural weakening of the yen. Since there is a surplus yen liquidity, the currency has lost its premium against the dollar. With the BoJ continuing its bond purchases, yen assets remain the lowest-returning among global markets. The latest change gives hope that yen-denominated assets may give slightly more returns to investors. Therefore, the yen has climbed sharply against the dollar. That said, the pressure on the yen continues as BoJ would continue to buy bonds and pump more yen into the economy.