The Bank of Japan Increased the YCC Flexibility & Raised its Inflation Outlook

Inflation Outlook

Inflation in Japan peaked at the start of the year, as CPI ex-fresh food rose to 4.2% y/y in January and the highest level since 1981. Although it has eased from this multi-decade high, it is still elevated and printed 2.8% y/y in September. More importantly, it has stayed above the central bank's 2% target for eighteen straight months.

In spite of these persistently lofty readings, the Bank of Japan remains cautious around the outlook and believes that more work is needed, in order to achieve price stability in a sustained manner. It still struggles to spur a virtuous price-wage cycle, following decades of deflation.

According to today's update though, policymakers believe that towards the end of the projection period (Fiscal 2025) underlying CPI is "likely to increase gradually toward achieving the price stability target" and raised their forecast. Median CPI (ex-fresh food) is projected at 2.8% y/y in the current Fiscal 2023 (ending March of next year) and at 2.8% for Fiscal 2024 as well (from 1.9% previously). ^[1]

Slow Path to Normalization

Due to years of weak or negative price pressures, the Bank of Japan has been implementing a super-accommodative monetary strategy. This makes it an outlier among its major counterparts, who have adopted aggressive tightening policies over the past couple of years.

Its toolkit includes negative interest rates (-0.1%), quantitative and qualitative monetary easing (QQE) and yield curve control (YCC). However, with inflation rising, the Yen has suffering from the ultra-loose stance and the YCC becoming harder to defend, the BoJ embarked on a slow path towards normalization nearly a year ago.

Under the YCC, the central Bank targets 10-year government bond yields at around 0%, allowing a fluctuation around this target, before stepping in with bond purchases. In December of 2022 it expanded this range to +/-0.5%, from +/-0.25% previously ^[2]. In July it took another step, making the YCC more flexible. Although the +/-0.5% target was maintained, the BoJ said it would offer to to buy 10-year JGBs at 1%, instead of 0.5%.

Increased YCC Flexibility

The Bank of Japan today loosened its grip even more, by deciding to "further increase the flexibility in the conduct of yield curve control". Officials now view the 1% target as a "reference" and not a hard ceiling as before, essentially allowing 10-year yields to move above that level. ^[3]

Although today's decision constitutes another step on the slow path to normalization, policymakers reiterated their dovish stance. They once again vowed to "patiently continue with monetary easing", in order to achieve the price stability target in a "sustainable and stable manner, accompanied by wage increases"

Market Reaction

Despite taking another step towards normalization, the Bank of Japan has adopted a piecemeal approach by making small and non-straightforward changes to the yield curve control. Although its governor had recently hinted to an eventual exit from negative rates, there is no immediate desire for such a shift and today's outcome underscores that.

The stark policy differential with its major peers and the US Fed has been detrimental to the Yen. Markets were underwhelmed by today's BoJ action and USD/JPY jumped as result. Reaction to the bond market was immediate as well. Japan's 10-year bond yield soared towards the 1% reference point.