From Negative Rates to the Unknown - Mapping Out BoJ’s Long-Term Policy Trajectory

• BoJ officials' recent remarks on policy normalization implications have created market ripples.
• Pre-emptive policy adjustments have been made, with current conditions necessitating a distinct approach for further changes.
• My updated projection anticipates a cash rate increase to 0.0% in 2Q 2024, advancing the timeline from 3Q, while slow normalization is expected to follow.

Governor Ueda of the Bank of Japan (BoJ) recently addressed Parliament, discussing potential shifts in policy dynamics once the central bank transitions away from the negative interest rate policy (NIRP). One consideration is the potential adjustment of the policy rate to the uncollateralized overnight call rate. This follows earlier remarks by Deputy Governor Himino, who suggested that exiting NIRP could have positive implications for households while minimizing the impact on corporations.

Premature and Gradual Transition Despite surprises from the BoJ in July, October, and December of the previous year, the current situation appears distinct. Exiting NIRP necessitates a firm belief that inflation is consistently progressing toward its target. Wages, a critical factor, await the announcement of the Shunto spring wage negotiation results in mid-to-late March. While certain major corporations have expressed intentions to continue raising wages, the crucial question remains whether small- and medium-sized enterprises, which employ approximately 70% of the workforce according to METI, can follow suit.

Encouraging December Tankan, but not a Catalyst for Policy Adjustment The quarterly survey of Japanese firms indicates an improvement in business sentiment among manufacturers and positive outlooks in the services sector. Crucially for BoJ policy considerations, firms' inflation expectations and capital expenditure intentions remain high. Additionally, the persistent labour shortage in service industries signals ongoing momentum in wage growth.

Advancing my Projection for Exiting NIRP to 2Q24 from 3Q24 The BoJ has initiated discussions on its policy trajectory earlier than initially anticipated. While acknowledging the dynamic nature of upcoming meetings, my central outlook anticipates the BoJ to abandon yield curve control (YCC) in 1Q24, followed by a policy-rate balance rate increase to 0.00% from -0.10% in 2Q24. Beyond that, until the end of 2025, I anticipate the BoJ maintaining a steady policy without progressing toward the terminal rate, which I estimate to be around 1.5%.

Why the rush?

Let's assess the status of households. Real wage growth and consumption are not robust now. While some positive factors, such as substantial winter bonuses this month and a one-off income tax cut next year, will offer relief, their impact on consumption is expected to be limited. Despite significant fiscal transfers during the pandemic, there has not been a substantial drawdown of excess savings in Japan, indicating cautious spending habits among Japanese consumers.

This cautious approach is why the BoJ has been deliberate in not hastily normalizing policy, given that improvements in medium-term consumption trends are not yet clear. The outcome of the Shunto spring wage negotiations in 2024, with the initial results anticipated in mid-to-late March, is crucial to building strong enough conviction that a virtuous cycle from income to spending is established. It is essential for demand-side pressures to sustainably contribute to inflation moving toward the price stability target.

Nevertheless, there are positive signs that provide the BoJ with leeway to adjust its rhetoric. Supported by the inbound tourism boom, services inflation is holding steady around 2% on a 3-month/3-month seasonally adjusted annual rate. Corporate profits, overall, remain high. The December Tankan quarterly survey indicates that inflation expectations are being maintained at elevated levels. Labor shortage sentiment across firms, especially in services, continues to persist, with expectations of further widening imbalances. Overall, these factors should contribute to upward pressure on wage growth momentum.

Thinking beyond?

While I anticipate the BoJ maintaining the current policy rate at 0.0% from 2Q24 through end-2025, it's essential to assess potential risks associated with the BoJ's actions beyond 2Q24. I outline my perspective on the framework post a NIRP exit, contingent upon significant improvements in Japan's economic fundamentals, though I emphasize that this is not my primary outlook.

Firstly, the exit from NIRP, while not inherently disruptive, poses a high hurdle for the BoJ to navigate into positive territory. Such an exit also implies a departure from the existing three-tier system, necessitating extensive discussions within the BoJ for subsequent changes. Despite my estimation of the terminal rate being positive at 1.5%, with a downward bias, the Japanese economy's performance remains subdued. The potential impact of policy rate hikes on JPY, amid a backdrop of weakening global growth, is likely to discourage rapid tightening. This prompts the BoJ to exercise caution when transitioning from an accommodative to a neutral stance.

Secondly, if rate hikes were to occur, their pace would be deliberately gradual. Japan's situation differs significantly from other developed markets. Unlike the Fed, ECB, and BoE, which initiated their hiking cycles before their economies experienced peak inflation, Japan's inflation has already peaked. Additionally, there will be an emphasis on maintaining a steep yield curve during the normalization of monetary policy to ensure a smooth exit.

As discussed in the recent monetary policy review workshop, conducting policy normalization when the spread between long-term and short-term interest rates is substantial will limit downward pressure on the BoJ's profits. While central bank profits don't directly impact operations, a loss in credibility can hinder the effective execution of monetary policy.

This implies that the normalization of the BoJ's balance sheet will progress gradually, with stringent criteria for any form of quantitative tightening. Given the BoJ's accounting method using the amortized cost approach, mark-to-market losses on bonds are not reflected in profits. As a significant buyer of Japanese Government Bonds (JGB) for years, owning more than half of the JGB market, the BoJ will need to incrementally adjust its buying presence to minimize market volatility. Although YCC adjustments have been announced to make it more sustainable, the cessation of JGB purchases is not expected, as monetary officials are likely to reinvest maturing bond holdings in the foreseeable future.

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