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The Bank of Japan tries to bend the yield curve

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Bank of Japan Gov. Haruhiko Kuroda attends a news conference at the central bank headquarters in Tokyo on Sept. 21.   © Reuters

TOKYO -- In Aldous Huxley's dystopian classic, whenever people feel blue they take a government-supplied hallucinogenic called "soma." The Bank of Japan and its governor, Haruhiko Kuroda, struggling to lift people out of their deflationary funk, may be wondering where they can get their hands on some.

The bank may have no such wonder-drug, but in its fight to raise inflation to its target of 2%, it has entered a brave new world of monetary policy: namely, "yield-curve control."

The Japanese central bank announced its latest policy change at its September meeting. It will try to keep the yields on 10-year Japanese government bonds, the basis for long-term interest rates, around zero.

Conventional monetary theory says that is impossible because long-term interest rates are affected by factors beyond the central bank's control, such as the government's fiscal policy, market conditions and inflation expectations. Historically, monetary authorities have focused on short-term interest rates, which they do control, to spur or rein in the economy. The idea is that lowering or raising rates at the short end of the yield curve affects long-term rates as well.

Making it happen

While it is true that central banks around the world have tried to lower long-term interest rates by buying longer dated government bonds, trying to keep the rates at a particular level, let alone around zero, is a whole different kettle of fish. At the time of the announcement, the BOJ was confident it could pull it off. "We have found through our bond purchasing and negative rate policy that the yield curve can be controlled," said one senior BOJ official. "Deciding the right interest rate level is what central banks have always done. It is not that different."

But five days on, and after a number of reports pointed out the difficulties, Kuroda appeared to try and dampen expectations. "The long-term interest rate cannot be completely controlled," he said at a news conference following a speech in Osaka on Sept. 26.

The decision to introduce a new policy framework was made partly out of necessity. Previous steps had been taken to increase the monetary base by 80 trillion yen ($792 billion) annually, mainly through the purchases of JGBs. "It was obvious that the central bank was going to run out of JGBs to buy," said Shuichi Ohsaki, chief Japan rates strategist at Bank of America Merrill Lynch. Tacitly acknowledging these technical limitations, Kuroda said after the September meeting that the new framework has "raised the sustainability of our monetary easing policy."

What matters to central bank watchers, however, is that the BOJ has repeatedly come up with unconventional and at times unpredictable tools to try and achieve the seemingly impossible.

When the central bank was left with no more room to cut nominal short-term interest rates after hitting the "zero lower bound," it resorted to aggressive government bond purchases to push down interest rates across all periods. When bond purchases were said to be reaching their limit, the BOJ brought in negative interest rates. That was something observers thought it would not be able to do because it would appear to undercut its asset purchasing program. Kuroda had also made it clear in speeches that he did not intend to adopt such measures. This time around, the BOJ is challenging monetary theory head on. The bank's track record has fostered a sense of unease in the market, and that has stirred up speculation of even more unconventional measures.

One such measure bandied about is for the government to issue perpetual zero-coupon bonds for the BOJ to buy, or replacing bonds currently held by the bank with perpetual bonds. According to the economists at HSBC, this would "cost nothing to service and offer debt-free financing for the government if [the bonds are] parked on the central bank's balance sheet." Another idea is for the BOJ to purchase foreign bonds. This proposal gained traction before the September meeting. Buying foreign bonds would push the yen lower, something the BOJ and Prime Minister Shinzo Abe very much want.

Experts note that both measures face legal hurdles. In the case of perpetual bonds, Article 5 of the Public Finance Law of Japan prohibits the BOJ from directly underwriting the public debt. Buying foreign bonds "with the intention of intervening in the currency market is forbidden by the Bank of Japan Act," according to Abe. But the HSBC economists said there is "wiggle room" for perpetual bonds if the amount is limited by the Diet. As for buying foreign bonds, the trick would simply be to declare the move is being made for monetary policy purposes.

No solo act

The problem of maintaining the potency of monetary policy is shared across the developed world.

In August, U.S. Federal Reserve Chair Janet Yellen said in a speech at the annual gathering of central bankers in Jackson Hole, Wyoming, that "fiscal policies and structural reforms can play an important role" in strengthening the economy. Mario Draghi, president of the European Central Bank, has said many times that monetary policy alone cannot lead to balanced growth. Kuroda at least partially agrees. "The bank believes that its monetary policy and the government's fiscal policy as well as initiatives for strengthening Japan's growth potential ... will navigate Japan's economy toward overcoming deflation and achieving sustainable growth," the BOJ said in its September statement.

But for now, all eyes are on the new policy framework and whether it will be the magic bullet that enables the BOJ to reach the 2% inflation target, offering a monetary policy tool for policymakers worldwide. "The central bank faces clear doubts over whether it has the tools to boost the real economy and deliver on the inflation target," ratings agency Fitch Ratings said in a recent report. "Moreover, its credibility could be further undermined by having to rely on ever more complicated policies to ensure it is helping, not hurting, the economy."

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