Transcript
Paul Diggle
Hello and welcome to Macro Bytes the economics and politics podcast from abrdn. My name is Paul Diggle, Deputy Chief Economist here at abrdn, and today we're talking about the Bank of Japan, where the central bank has been fighting with financial markets, which are testing the peg on its yield curve control. And there's now a new Bank of Japan governor incoming. And it's become a crucial theme in financial markets whether the yield on Japanese government bonds, which has for so long been kept very low by the central bank's intervention is about to shoot higher. So, I'm delighted to be joined by Sree Kochugovindan, our Senior Economist covering Japan here at abrdn to talk all things Bank of Japan. So, Sree, I thought we'd start then by just outlining why Japan has plotted such a different course both economically and in terms of its monetary policy over the past decade, or indeed several decades compared to the other advanced economies. What's been happening differently in Japan than everywhere else?
Sree Kochugovindan
Well, I think, to provide a very brief macro backdrop, it's very important to go back to the mid-90s actually, in order to get a real sense of the context for today. So, Japan has been incredibly distinct. And the root of this has really been the bursting of the credit and stock market bubble from the mid-90s, land prices started declining in 1991 and fell over 50% over the course of 15 years. We had incredible volatility across the stock market up nearly 500% during the 80s, then down again 60% over the 90s and all of this together has really weighed heavily on the growth outlook for Japan, seeing very large output gaps and that was the dominant reason behind deflation for many years, stagnant wages has been the backdrop. And in response to all of this, the BOJ has obviously had a very tough job, they cut rates to 0.5% back in 1995. That was unprecedented for the time, really cutting-edge policy. They pushed it to 0% in 1999 but deflation had already set in and even the Western Corp, which excludes both food and energy, even that continued to fall to minus 1.1% in 2011 and stayed in deflation through to 2002. So, despite the rate cuts, it was a very difficult backdrop and Japan endured decades of slow growth, persistent deflation, stagnant wages. And then I think the other important thing to note would be post GFC around 2011 – 2012 there were a series of events that were very disruptive. So, first of all, the Tohoku earthquake/tsunami, the nuclear leak, plus a very sharp appreciation of the yen. Given its safe haven status, we have the euro area sovereign debt crisis in the background, and the yen saw safe-haven flows as a result. So, this combination was very detrimental to the inflation backdrop, and the growth backdrop, and it eventually led to the election victory for Prime Minister Shinzo Abe. And then we saw the start of Abenomics, at which large-scale monetary stimulus was the main policy tool and the most important of the three arrows that we've heard so much about. Now the main aim of this, the hope was to raise inflation expectations through higher credibility and higher commitment from the BOJ. Japanese inflation managed to break out of deflation very briefly, but it rarely saw headline CPI in excess of one and a half percent and mainly it oscillated around 0% for most of the time. So, a difficult backdrop there for the BOJ really. I'd say those are the main reasons why it stands out.
Paul Diggle
Great. So that's a brilliant sweeping history of the Japanese economy over many decades. So, into that backdrop, then has stepped, as you say, the Bank of Japan and used a variety of tools, often at the cutting edge of global monetary policy to try to raise inflation and fight deflation. And those tools Sree have been negative interest rates, quantitative easing, and then most recently yield curve control. Could you talk us through what yield curve control is then? What's the central bank doing with this new instrument?
Sree Kochugovindan
Yes, so yield curve control came off the back of a number of cutting-edge policies, as you say QE very slow start there. We have the shock and awe strategy in 2013 through Abenomics. Very large Japanese government bond purchases there. However, none of those policies actually managed to improve the inflation backdrop, because really, it's about the central bank's ability to impact the business cycle through real rates of interest. And we needed an extra tool, given that we were still stuck in very low inflation or deflation during that time. So even with a zero-interest rate policy or negative interest rates, it still might be too tight. Hence the need for yield curve control. So, in September 2016, there was the announcement of QQE plus yield curve control or YCC. And there you set the target around 0% for the 10-year, Japanese government bond yield. So that was very close to the prevailing rate at the time, actually. And also you have the target rate of 0% and you have the fluctuation around that of plus or minus 10 basis points was the original announcement. So that was really quite helpful initially. And the aim was to really take control of the whole yield curve, flatten the yield curve, in order to help stimulate the economy help to provide greater certainty, and again, then possibly generate some inflation through stimulus that way. As a result, yield volatility was lowered for a period of time. But obviously, recently, that part's been quite a different story altogether.
Paul Diggle You can't understate actually how radical a policy yield curve control was when the Bank of Japan first introduced it because this mindset shift at the central bank could set not just the administered short rate, the overnight rate that we’re used to other central banks doing, but it could also in turn, directly set long term market interest rate through effectively fixing the price of a particular market rate. That was a pretty big mindset leap. Through Quantitative Easing, the idea is to influence long-term market interest rates through the quantity channel by adjusting the amount of an asset you buy, you might in turn, influence its price. But here, the Bank of Japan was directly saying the price of JGBs or put another way, the yield on them, will be set by us. I think it's such a huge imaginative leap that they made. And of course, Sree, a credible yield curve control framework would actually mean the Bank of Japan not having to purchase large amounts of JGBs to set that yield, it would just happen because it was credible, the market would set the yield at that level. But the story on the contrary, though, has been that yield curve control has been under growing pressure in recent years and market speculation that the yield won't be maintained at the Bank of Japan's target rate. Could you explain why we've had this pressure on yield curve control the speculation that the policy could actually end?Sree Kochugovindan
Yes. And that's quite a marked shift, actually, because, as you mentioned, yield curve control did initially come with some credibility. Did lower the volatility in bond markets. And the Bank of Japan actually had to purchase fewer bonds for a number of years, there was less pressure to purchase bonds. So, what's shifted literally in the last year, there have been a number of changes. First of all, global inflation pressures have been incredibly strong, as we're all aware. And in response to that global central banks have had to tighten policy very aggressively. And the BoJ has been the one outlier in all of this. And since early 2022, the BoJ has widened the band twice, but the most surprising was in December. Throughout 2022 there’d had been a lot of speculation because of the divergence in yields, but also because of the pressure on the yen. And a rapid pace of depreciation is not good for business sentiment, and it removes some of that certainty in terms of business decisions. It's the pace of depreciation that's more detrimental. But what was interesting was the move in December was incredibly surprising because the BoJ had quite aggressively defended the ceiling to yield curve control for the entirety of the year and just as the hawks are throwing in the towel and accepting, just as they've won the credibility battle, to an extent, then they decided to move and introduced turmoil again back into the markets. One other feature actually that I forgot to mention was the fact that there's a new governor coming in April. That was part of the speculation as well. Will this come with a big regime shift? What does pm Kishida want? Lots of questions were raised and along with the yield differential, it was a perfect storm really for investors.
Paul Diggle
So, people sometimes talk about control being a distortionary intervention by the Bank of Japan or somehow unsustainable, and the Bank of Japan has at times spoken about market distortions as well from its own policy. What exactly is distortionary about control? Or put another way, how does it adversely affect market functioning?
Sree Kochugovindan
Yeah, a number of different channels here. It limits the function of the bond market, obviously, with an artificial cap. It reduced liquidity and depth in the market. Just prior to the December policy meeting and the decision to tweak the band there had actually been a meeting with dealers where these issues had been raised. And these concerns had increased over time. And also it's very costly for the BoJ. They own around half of the JGB market, they own most of the 10-year sector. And actually, for some of the issues of 10-year JGBs, they own more than 100%. And that's due to repurchases, where you lend out the bonds and buy back. And there can be some double counting there in terms of ownership. And also there was the perception from the markets, from some investors, that the macro backdrop no longer justifies it. So optically inflation is at historic highs, if you look at the headline number, but much of this is imported inflation, much of this is energy, food prices, transitory. It's not the domestically-generated inflation that you need. But optically, it looks very high. And a lot of investors are saying, headline, inflation is well above target, it's time to adjust. So I think all of those pressures have really been the key story throughout 2022. It's been very difficult for the BOJ.
Paul Diggle
So, as you were saying in December, some of these pressures crystallised when the Bank of Japan tweaked the band on its yield curve control. And effectively that was actually a tightening in monetary policy, because by expanding the band, the Bank of Japan allows 10-year JGB yields to trade in, it was always obvious that they would then immediately move to the top of that trading band, because that was, as he's been saying the pressure the market was wanting to put on the yield curve control cap on yields. So, it was a tightening policy de facto. So, what was their thinking, the Bank of Japan's thinking, when they widened this band, because the reality has been one it tightened monetary policy but two, it only increased market pressure and speculation and even the unsustainability of yield curve control. What were they thinking?
Sree Kochugovindan
That's absolutely right. So the official line is that this was particularly targeted at dealing with the distortions in the market. Within the bond market. They said quite explicitly that this is not intended as policy normalisation or monetary tightening. It's not intended to pave the way for the new governor. So that was the official line there. And they've also been very, very clear in terms of their outlook for inflation. Even in the January policy meeting, the forecast for inflation was adjusted in the short term, but the 2024 outlook remains unchanged and below the target, the central bank target. So it's very clear in their messaging that believe that inflation pressures are transitory and that there is not enough domestic inflation pressure. And that has repeatedly come up in various speeches, and press conference statements. However, there is actually, exactly as you say, there's a credibility issue that has been introduced by the move in December. Because if it was about just market distortions, that was a complaint we've had throughout the year, the yield differentials were there throughout the year. And they moved just as other central banks were reaching the peak. So there was, in a sense, less justification to move compared to earlier on in the year. And also it was close to the expected peak in domestic inflation as well. Just a few days ago, we saw the release of the CPI figures, the latest CPI figures are at 40-year historic highs. However, even Governor Kuroda expects that to be the peak. In February onwards, there'll be an adjustment in terms of government subsidies filtering into energy prices, and we'll start to see that disinflation and base effects feeding through. So, the timing, I think, also confused investors and introduced volatility into the market and turmoil. So, there's the official line, and then there's the interpretation of it. And I think communication is key.
Paul Diggle
So let's talk about some of those macroeconomic fundamentals then the inflation developments, the output gap, and how those things look in Japan because an outsider to the Japanese economy might say, well look, headline inflation is more than double the 2% target. It's risen as indeed it has everywhere else in the world. While other central banks have raised interest rates and tightened much policy substantially the Bank of Japan still has its yield curve control framework, and very, very low interest rates. Doesn't the macro economy actually justify tighter monetary policy? How would you think about those issues?
Sree Kochugovindan
I think Japan is very different if we compare it with other economies, particularly with the US or UK - places where you have very, very tight labour markets, and very strong wage pressures there, it's a very different story in Japan, where if we focus on the domestic story, the outlook is still quite subdued. So services inflation is still very subdued, it's in the region of sub-1%. When you strip out food and energy, the outlook again looks as if you know, in line with the history, actually, it's no different from the longer-term history if you look at the underlying inflation pressures. So, the real optics, as I mentioned, would be coming from the energy prices. Now, the base effects from liquid natural gas, for example, suggest that over the coming six months, there's a very sharp deceleration, in headline inflation as a result of this base effect from fuel. The same again, for food prices, and goods, inflation is also peaking. So that has if you look, there's a lag of five to six months for goods, inflation, and that's set to roll over as well. So, there's a number of different drivers that are really starting to roll over. So, it's services that are the key where you need to see domestically generated inflation. And that really depends on the wage outlook. And a key event that's coming up is the spring wage negotiations of the Shunto wage negotiations. And that's going to give a very strong indication, I think in terms of policy. Now, we have seen some wage pressures picking up but those are not necessarily in the core wages. Core wages are still in line with the long-run history of Japan. The big spike that we saw recently in wages was from one-off payments, bonus payments. Again, these are transitory and very typical of this time of year. So it's not giving us that strong signal of wage growth. There is a possibility that inflation expectations could start feeding through into wage pressures, but we haven't seen it yet. And I think this spring will be quite critical in terms of really determining that outlook.
Paul Diggle
So then into this mix steps, the new Bank of Japan governor Kazuo Ueda. Tell us about him. I mean, the market has very quickly tried to come to grips with who is he? What's his background? Is he a hawk? Is he a dove? What's he going to do about the yield curve control framework? You've had to come to grips with that as well. So how should we understand this new Bank of Japan governor?
Sree Kochugovindan
Yes. So I think the first thing was he was a surprise nomination, everyone had been expecting deputy governor Amamiya to be the next candidate for nomination. And there was a list of other potential front runners. Kazuo Ueda was not on that list. So there was no previous analysis of him. But what we do know is that he is a 71-year-old academic. He received his doctorate from MIT. He was supervised by the former Fed Deputy Chairman Stanley Fischer. He teaches at the business faculty at Tokyo's Kyoritsu Women's University and holds an honorary professorship at the University of Tokyo. Importantly, he is considered as one of Japan's foremost experts on monetary policy. He's highly respected. He's not a traditional theoretical academic, he has a keen interest in markets. He was also a BoJ board member between 1998 to 2005. And he was one of the two board members who opposed ending their interest rate policy in August 2000. So initially, that was one of the pieces of information that investors grabbed to say, oh, he's a dove. But then there are other pieces of information where he’s interpreted as a hawk. So, perception has really swung quite violently between the two, across the spectrum, because there is so little information. Last year, I thought there was an interesting statement that he made where he didn't feel that incremental changes to yield curve control were, what would be helpful. And obviously, we saw the impact of that in December, but since then, he's been very neutral. And we've had a couple of parliamentary confirmation hearings. And that's been analysed and scrutinised very, very closely by markets. So, what do we know so far? We know that he has backed policy continuity for now, given the extreme uncertainty around the economic outlook, both within Japan and globally. Second was if exit were to begin policy, normalisation, that would only be if the target of stable 2% inflation had been reached. And there was clear evidence of that. He also said this morning, so we're just recording this just a few hours after his second confirmation hearing. So, he mentioned the benefits of BoJ stimulus outweigh the costs. But that statement to me it just references a broad set of policy tools, you know that that could easily be maintained as true. He has avoided yield curve control comments for as far as possible. But when questioned over shortening the target maturity from 10 years to five years, so having that cap around five years, instead, Ueda responded that it was just one of many options that they were considering. He also acknowledged today, and I think this is quite meaningful that some policy shifts were needed to avoid speculation. He actually used the phrase ‘surprise policy shifts’. So, first of all, the next move again will be aimed at blindsiding the market, it will be a surprise. And it's also showing a signal, which is a bias toward tweaking yield curve control. That's how I would interpret the overall package of very, very neutral, really carefully worded statements. I think this one was quite interesting, actually,
Paul Diggle
So, to have this combination, then of a yield curve control framework, which is under increasing market pressure, with substantial speculation about it potentially being abandoned. A macro economy that currently shows above-target inflation, but you've articulated the reasons why that looks particularly transitory and temporary in Japan's case albeit much depends on the Shunto spring wage round, and what happens to it in terms of domestically generated service sector inflation, and then a new governor, that people have been trying to parse for any hints on his views of yield curve control. So that's the combination. What does it all mean, then for the future of the yield curve control framework? What do we, you know, have we got alternative scenarios, what do we think is actually going to happen to this key aspect of global monetary policy?
Sree Kochugovindan
I do think the base case is for a widening of yield curve control policy. Now the window of opportunity there is very, very narrow, he has been very clearly data-dependent. So, it's very, it's very difficult to call. And it seems almost 50-50, actually, in terms of, you know, the outlook for this year. But I'd say it's now leaning more towards a widening of the band; we'll get more information over the coming weeks in terms of wage negotiations and the progress there. And obviously, more statements and speeches. Later this week, we have the hearings of the two deputy governor nominations as well. So we'll try and gather some more colour there. However, my bias at the moment, would be for us widening towards 75 basis points, really, because, you know, it's something that hopefully wouldn't create too much turmoil in the market. There is the potential for a 1% as well, you know, if you really wanted to surprise and make a quick move, I mean, he did say after all a year ago that small tweaks are not helpful, but a widening, nonetheless, would be the case. Now the window of opportunity, I would say very soon after he takes the helm, possibly by the June meeting, April, June. I think, if we wait too long, there could be a shift from the macro backdrop. I've already mentioned that the macro doesn't really justify it, in my view, if you look at the underlying inflation pressures. So, I think by the time we get to June, July, couple of things, the domestic outlook will become much clearer in terms of wage pressures, and inflation expectations, and the optics of headline CPI will start to decelerate quite rapidly. And you'll see this transitory story much more clearly. That's one thing. The second thing is we're starting to see growth weakness elsewhere. And if we enter this period of a global recession, obviously, the timing of that is still fluid, then again, this yield differential argument becomes less strong in essence. Even if policy rates remain elevated elsewhere, it becomes more of a focus in terms of, you know, what about the future for 2024? Are people going to start cutting rates, you know, I think the market sentiment will start to shift and look ahead. So, I think if there is going to be a shift, it will be quite soon. And if it doesn't happen by then I have to say, I think it's unlikely that we'll see any change. So that's the yield curve control. In terms of everything that we've heard so far, I think negative interest rates are here to stay for the rest of the year, at least, possibly well into next year. There doesn't seem to be enough justification for a shift in interest rates. This market distortion is purely as a result of yield curve control. There is no justification for monetary normalisation at this point from a macro perspective. So I don't see any change in that negative interest rate policy. This is very data dependent. It's not a strong view. It’s not the same level of conviction as I had last year. It will be more of a 60-40 call in terms of this outlook, but there are lots of uncertainties there with regards to the new governor's decision.
Paul Diggle
And then would a tweaking of the framework mean that speculation about an eventual wholesale abandonment of yield curve control, would that really keep that speculation alive in the same way that the December tweak to the 10-year JGB yield target, only increased speculation about the future of the policy? So, would the Bank of Japan actually be causing itself problems by continuing to tweak the framework?
Sree Kochugovindan
Yes, I think, I mean, we saw that in January. It was a surprise that they didn't move, there was so much pressure in the run-up to that meeting. And I think there's a risk of that, again, in the coming meetings, maybe less so in March, because that's currently viewed by some as a lame-duck meeting. But then, you know, as we move into the new governor's time, as I mentioned, communication from him was going to be critical. And he has been very careful in toeing the house view for now. But by the time he takes control, there will be some more clarity in terms of that data. So I think there will be in sum, to answer your question, I think there'll be possibly less of a market turmoil than you know, than we've seen, say in December or January. It really depends on the communication, and how he signals the path forward. I mean, in terms of, you know, just running some fair value models on JGB yields, one thing we need to remember is the importance of global yields. One of the biggest drivers of JGB yields statistically is US Treasury yields. So the Fed’s action is also playing a role in this in the JGB market. And that's something that the new governor Ueda will need to consider as well. So it's the domestic story, and the global story. And you know all of this will be a feature in the April and June meetings. But as I said, as we move beyond that, I think it's going to become harder to justify a move from a macro perspective.
Paul Diggle
Well Sree Kochugovindan, I thought that was a great canter through this important debate in global macro and in markets. So, thank you very much for your insights. And thank you for listening to Macro Bytes as ever. If you're enjoying the show, please like and subscribe on your podcast platform of choice. We're back in two weeks’ time with something slightly different. We're going to look at the rise of retail investors, their access to research and analysis and the role of financial influencers. So don't miss that. But in the meantime, goodbye and good luck out there.
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