The Bank of Japan (BoJ) has today started its two-day monetary meeting and will announce its interest rate decision early tomorrow morning.
- Despite the recent dismal economic indicators, we expect BoJ to leave its leading O/N target rate unchanged at 0.1%. Most BoJ board members believe that cutting the O/N interest all the way to zero will disrupt the good functioning of the money markets. Hence, in our opinion, BoJ is unlikely to cut its O/N target rate further. O/N forward interest rates for future BoJ meetings are priced very tightly at around 0.1% for the rest of year, so this is the view of the market too. Hence, it would be a very big surprise if BoJ were to cut interest rates tomorrow.
- With the Japanese economy currently deteriorating fast, there will be increasing pressure on BoJ to accelerate unconventional easing measures. Tomorrow BoJ will probably announce an extension of its commercial paper purchase programme, originally scheduled to run until April. In addition, BoJ will probably announce plans to purchase corporate bonds outright in the market. Finally, it cannot be ruled out completely that BoJ will increase its target for the purchase of government bonds (current target JPY16.8trn yearly).
- Nonetheless, BoJ's non-conventional easing measures have been modest. Measured by the increase in central bank balance sheets, BoJ is far behind both the Federal Reserve and the ECB (see chart 3). Hence, BoJ needs to start to boost its balance sheet and monetary base much more aggressively to get a substantial impact on bond yields and JPY. However, should BoJ start to boost its balance sheet and monetary base as it did during its quantitative easing regime from 2001 to 2002, there could still be room for Japanese bond yields to decline further (see charts 3 and 4) and it might help to avoid further JPY appreciation.
- While we do expect some unconventional easing measures tomorrow, they are unlikely to be aggressive and hence the market reaction is likely to be limited (bond yields slightly lower, particularly shorter maturities and no significant impact on JPY). The big question will remain if there really is a lot BoJ can do. Japan has been hit by an extraordinary external demand shock, not a domestic credit crunch. Lending growth has actually been quite robust in recent months contrary to the quantitative easing years from 2002 to 2006, when credit contracted sharply (see chart 6).
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