BOJ's takeaway from Fed bungle: keep the message simple

Reuters
Bank of Japan Governor Haruhiko Kuroda gives his speech during a seminar in Tokyo
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Bank of Japan Governor Haruhiko Kuroda gives his speech during a seminar in Tokyo September 20, 2013. …

By Leika Kihara

TOKYO (Reuters) - The U.S. Federal Reserve's surprise decision not to start tapering its massive stimulus convinced the Bank of Japan about one thing - the need to keep market expectations anchored with a simple, clear message.

BOJ policymakers have sprung into action since last week's Fed gathering with the most explicit explanations to date of how the central bank will measure the success of its own policy - turning years of deflation into 2 percent inflation.

In so doing, they have indicated the central bank's economic stimulus could remain in place after two years, the timeframe it gave in April for getting to 2 percent inflation, and so implying that it is a long way from even considering its own exit strategy.

They want to avoid the sort of market volatility triggered by the Fed, which for months had flagged it could rein in its economic stimulus before the end of the year, prompting markets to expect an announcement at last week's meeting. Fed Chairman Ben Bernanke had suggested the stimulus could stop by the middle of 2014.

People familiar with BOJ thinking say the central bank wants to pre-empt questions about its policy following the Fed's meeting. They think the Fed had been too specific in identifying the conditions that would trigger a tapering of its stimulus and in the end that made it difficult to avoid causing a market upset.

"Offering a lot of guidance doesn't necessarily heighten transparency on monetary policy," said one of the officials familiar with the BOJ's thinking.

The officials declined to be identified because they are not authorized to speak publicly.

Japan is years away from engineering an exit from its own huge stimulus. But since it is following similar policies to the Fed it had more than a passing interest in the U.S. central bank's meeting. The Fed injects $85 billion into its economy each month, while the BOJ injects about 7 trillion yen ($71 billion) - policies known as quantitative easing.

TIMING

The Fed's decision to delay the start of tapering surprised not only markets but many BOJ officials. The Fed's forward guidance had heightened, rather than diminished, confusion over the course of policy, some said.

In their eyes, the more the Fed offered guidance on the potential timing of policy turns, the less leeway the U.S. central bank left itself to make adjustments later if economic conditions changed.

"Don't talk too much about the policy outlook, particularly about the timing of an exit," said a source with direct knowledge of the central bank's thinking. "That may be the takeaway for the BOJ from what happened last week."

The big fear for the BOJ is that markets start to factor in a change in its policy too soon, as they did with the Fed.

"The Fed was only trying to scale back stimulus, not tighten policy. Still, markets got ahead of themselves and long-term rates shot up more than expected," BOJ board member Takahide Kiuchi said hours after the Fed's decision.

To try to avoid any misunderstanding about BOJ policy, some board members moved quickly to spell out what the BOJ's end game looks like.

Although the BOJ launched its massive stimulus campaign in April, it had been largely coy about describing the conditions that would signify it had met its policy goal of 2 percent inflation, raising questions in markets.

Would it rein in stimulus even before 2 percent inflation is reached if it felt economic momentum was such that 2 percent inflation was certain? Or would it maintain stimulus even after data showed inflation had reached 2 percent in order to ensure the rate was maintained?

In a speech delivered two days after the Fed decision, BOJ Governor Haruhiko Kuroda suggested simply reaching 2 percent would not be enough. Instead, the inflation level would have to be inbuilt into Japanese expectations.

"To use the metaphor of the anchor, the aim is to set the 2 percent anchor deeply in people's understanding and make the observed inflation rate hover around that anchor," Kuroda said in a speech. "That is what the BOJ means when it says 'maintain 2 percent in a stable manner'."

And in the most direct comments by a BOJ policymaker that stimulus could continue beyond the two-year timeframe set for reaching 2 percent inflation, former IMF economist Sayuri Shirai said a key message of the central bank is that it will not consider an exit unless the inflation target is achieved.

Such guidance "warrants any necessary actions by the bank beyond the two-year horizon," she said.

"(The) guidance plays an essential role in reducing volatility of long-term interest rates, and in preventing them from overshooting," Shirai said.

ANCHORED

The people familiar with BOJ thinking said it was crucial for the central bank to keep inflation expectations well-anchored because any sudden spike in bond yields will inflict far greater damage on the economy than in other countries because of the need to fund Japan's huge public debt.

At more than twice the size of its $5 trillion economy, the debt is the heaviest burden among industrialized countries. So it is critical to curb any unwelcome spike in bond yields to keep borrowing levels manageable.

To be sure, the BOJ can keep its message simple for now because its policy course is nowhere near a turning point. In fact, markets doubt the BOJ can boost inflation to 2 percent in two years even though core consumer prices are rising at 0.8 percent a year. Two-year bonds barely yield 0.1 percent and 10-year bond yields are only 0.6 percent.

But BOJ policies will face much deeper scrutiny when inflation does finally approach 2 percent, much like it did under its previous quantitative easing program in 2001-2006, when it had pledged to maintain stimulus until consumer prices were "stably above zero".

As early as 2003, bond yields jumped as an improvement in the economy sparked expectations policy may be close to a turning point. The BOJ spent the remaining years of its quantitative easing program reminding markets its ultra-loose policy would remain in place.

"Long-term rates may rise more than expected if price rises gather pace. When that happens, the BOJ may need to fine tune its message on an exit," a source familiar with its thinking said.

A former BOJ policymaker, who was on the board during the previous quantitative easing campaign, said Bernanke was trapped because the Fed was too specific in its timeline.

"You can plan early and lay out scenarios for tapering. But you don't have to share all that information with markets, when you know things may not go as initially planned," this person, who has close contacts with the current members of the board, said.

(Editing by Neil Fullick)

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