The inside story of the BOJ’s great monetary experiment

Yen 970 PxFormer Bank of Japan insider Sayuri Shirai shared her thoughts about unleashing the world’s greatest monetary experiment. As a BOJ Policy Board member under Governors Kuroda and Shirakawa, Shirai helped determine Japan’s monetary policy between 2011 and 2016. “This was a rare opportunity,” she told Beacon Reports, adding, “Probably we can never do this again.”

On her watch, the BOJ greatly expanded its balance sheet to try to reflate Japan’s economy. Comprehensive monetary easing measures introduced earlier under Shirakawa had little effect. Well-known economists openly criticized the BOJ for not acting more boldly, as did some other central bankers (in private). “Some central bank staffs criticized me strongly,” reports Shirai, who personally felt that it was important to experiment with maximum monetary accommodation to raise aggregate demand, overcome deflation, and “correct” yen overvaluation.

Stock prices shot up and the yen devalued at the start of Abe’s second term as Prime Minister in December 2012, in anticipation of quantitative and qualitative easing (QQE). Even Kuroda, who assumed BOJ governorship in March 2013, believed the BOJ could achieve its 2% inflation target within two years. However, Shirai always felt the target would take longer to achieve. “My initial assessment was at least three years for inflation just to get closer to 2%,” she says, because of adverse affects from shocks like future consumption tax-hikes. Four years later, inflation was still falling far short of target. The BOJ responded, doubling down by introducing negative interest rates in January 2016.

Negative rates aimed to stimulate further bank lending. It did, but also squeezed bank lending margins. Bank spreads had already fallen to below 1% because of QQE. Negative rates caused short-term rates to fall further and the yield curve to flatten, squeezing bank margins even more. All told, the increase in bank lending failed to offset decreasing margins. Insurance and pension funds were also affected, as they must hold Japanese government bonds (JGBs) to prevent asset and liability mismatches. The entire financial industry howled over negative rates. Largely to appease them, the BOJ introduced yield curve control in September 2016.

Under yield curve control, the central bank manages a moderately upward sloping yield curve whose 10-year bond rate is pegged around 0%. That took pressure off financial institutions, especially insurance and pension funds that hold many long-term bonds. “The September policy announcement was the BOJ’s acknowledgment that they had made a mistake by introducing negative interest rates,” says Shirai.

In practice, the BOJ had little choice. It already owns 42% of the JGB market. To buy added assets, it overpays, bidding up prices ever further—setting the stage for BOJ losses when it finally seeks to normalize monetary policy. When it does, interest rates will rise, causing the BOJ to pay more to financial institutions on unused funds parked at central bank capital accounts. Until the BOJ’s vast bond holdings rollover into bonds paying higher coupon rates, it will suffer ‘reverse income’ flows. That is not a problem today, but could become one if the BOJ continues its massive bond purchasing over many years, notes Shirai.

The BOJ already owns over 60% of the Japanese exchange-traded fund (ETF) market too. It continues to bid up ETF prices by buying at the current rate of ¥6tn each year. It risks suffering technical negative equity, should the stock market plummet. That could happen when the BOJ begins to unwind its ETF holdings, signaling lower stock prices ahead.

The central bank is thinly capitalized, holding just ¥7tn in capital and reserves against total balance sheet liabilities of ¥491tn (1.4%). A sudden collapse in the stock market together with ‘reverse income’ caused by normalizing monetary policy could force the BOJ to recapitalize—risking the institution’s credibility as an independent arm of government.

“If the BOJ continues its current level of massive monetary easing, it’s not going to be good for the BOJ’s balance sheet. I think it’s time for the BOJ to make monetary easing more sustainable,” says Shirai, adding, “Sooner is better.”

Dr. Shirai is Professor at Keio University. She was a Member of the BOJ Policy Board between 2011 and 2016. She is author of a new book titled, ‘Mission Incomplete: Reflating Japan’s Economy’.

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