BoJ decision constrains further policy options

The hurdle for straight-forward expansion of asset purchases has actually risen: The Bank has made its job of deflation fight easier by pushing back the expected timing of 2% inflation for the second time and reaching for alternative tools (in this case negative interest rate) to address downside risks to the economy.

The decision to introduce the new tiered rate system was apparently controversial within the Board as four members (out of nine total) voted against the measure. Modest negative shock might be countered with additional rate cuts for excess reserves instead of the expansion of asset purchases.

Despite Kuroda’s ostensible comfort on bond market illiquidity resulting from the BOJ’s JGB purchases, it does appear that the issue is constraining the Bank’s policy adjustments somewhat.

Inflation trajectory might be more internally driven if banks react positively to the new tiered rate system: The important new development is the possibility of widening gap between interest on excess reserves (IOER) and interest on required reserves (IORR).

The continuation of asset purchases means that the banking sector as a whole will accumulate more and more excess reserves that are not exempted from negative interest rates. For commercial banks, one way to avoid this penalty is to create more loans, which naturally reduce excess reserves and create more required reserves. If the banking sector responds positively to this new incentive, then credit growth can accelerate and lift domestic inflation despite negative external environment.

Spring wage negotiations and Q1 data will be crucial for future policy outlook: The upcoming wage negotiations (called “Shunto”) will provide very important evidence for the economy’s underlying inflationary dynamic. Very weak industrial production and retail sales data from December (which creates the risk of another reading of “barely positive” GDP growth in Q4 2015) also raise the stakes for macroeconomic data in the current quarter.

Substantial disappointments on these two areas could force the BOJ to go for the combination of asset purchase expansion and additional rate cuts for excess reserves.

Homin Lee, regional economist Asia at Lombard Odier

 

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