- We think that the BoJ’s new policy framework sets the stage for further easing to back up its inflation commitment
- However, given the BoJ’s more cautious stance, we no longer expect a rate cut this year
- We expect the BoJ to cut policy rates by 10bp to -0.2% in 2017
- We think that delaying stimulus will result in lower inflation than we had initially projected. Our inflation forecast is now -0.2% for 2016 (was -0.1%) and it remains 1% in 2017.
- USD/JPY range in 2016: 100-104; 110 in 2017
Yield curve control vs more stimulus…
On 21 September, the BoJ fine-tuned monetary policy, but did not expand stimulus and kept QE purchases and negative rates on hold. The BoJ also announced that it will continue expanding the monetary base until the year on year rate of increase in the core inflation exceeds the price stability target of 2% and stays above it in a stable manner. We think that there are three main reasons for the recent policy announcement: First, it gives the BoJ time to evaluate the effectiveness of the measures taken earlier this year, particularly negative rates; second by targeting 10y yields at 0% it reduces the impact of negative rates for the financial system; and finally this cautious approach cools down expectations for additional easing, which was considered highly likely until recently.
…unlikely to boost inflation expectations
We are sceptical that the BoJ’s recent measures will revive the economy. We think that the BoJ will have to control the yield curve for some time before growth starts picking up. In the short run, the recent measures will mainly give support to the financial system as higher medium and long term interest rates will increase bank’s interest income and profits. However, we do not expect this to be meaningful. One of the reasons is that the duration of banks’ bond holdings is around 3-5 years and loan duration is 3-4 years. Moreover, it seems that a weaker JPY would be more positive for banks’ profits. On top of this we think that this framework is unlikely to boost inflation expectations materially as the BoJ’s JGB purchases may fluctuate either upward or downward to achieve the target level of long term interest rates (which may be changed in subsequent monetary policy assessments).
Negative rates most effective option for easing
We conclude that the BoJ has become more cautious in easing to ensure the sustainability of policy. However we still think that the BoJ needs to do more. We also think that cutting the negative rate further remains the BoJ’s main option for future easing going forward (notwithstanding potential changes in their yield curve target). The BoJ has explicitly mentioned the possible options for further easing in its most recent communication. Moreover, Governor Kuroda has said that negative rates can be effective in supporting a weaker yen. However, the BoJ seems to have no urgency. Their assessment is that about 50% of the deviation in inflation is due to a decline in crude oil prices. Hence the BoJ is taking its time to evaluate previous policy measures and the impact of the new policy framework in combination with QQE. This will also give banks time to adjust their business models to the prospects of lower rates by bolstering non interest rate income.
Changes in our forecasts
We now no longer expect further rate cuts this year. However given the BoJ’s commitment to overshoot the inflation target we think that in 2017 the central bank will announce one rate cut (-0.20%). Our assessment is that a combination of further rate cuts, fiscal stimulus that is supportive to growth and structural reforms which reduce the impact of an aging population, including reforms in the labour market, will be more effective in supporting the economy. We maintain our GDP forecast this year at 0.6% in 2016. We see some upside risks to growth resulting from somewhat stronger external demand, particularly from China. Inflation, however, should edge down further to -0.2% in 2016 from 0.1% previously. In 2017 we maintain our GDP growth forecast of 0.7% and inflation of 1%.
Implications for USD/JPY
We do not see any material reason to change our forecasts for the JPY because we see offsetting factors. On the one hand, we have changed our view on the BoJ. We no longer expect the BoJ to cut rates further into negative territory. This should give support to the yen as financial markets still partly anticipate a rate reduction. On the other hand, we expect investor sentiment on global financial markets to remain relatively constructive and this should result in low demand for the yen from a safe-haven point of view. Therefore, USD/JPY has some upward bias.
Moreover, we continue to expect a Fed rate hike in December which is for 60% priced in. This should result in some appreciation of the USD versus the yen. In addition, one of the important drivers for yen strength this year has been higher real yields in Japan versus the US. We think that this move has run its course and therefore the upward momentum in the yen will abate. We expect USD/JPY to trade around 100-104 for the rest of this year. In 2017, we expect an improvement in risk sentiment (as global growth gathers momentum), further rate cuts in Japan and tighter monetary policy in the US. This is likely to weigh on the JPY towards 110 against the USD.