YCC adjustments
Further adjustments to the BOJ's Yield Curve Control (YCC) policy framework are possible but not highly probable at the upcoming October 31 meeting. These considerations arise in response to the backdrop of increasing global interest rates, outflow of JGBs, and yen depreciation. Potential options include widening the 10Y yield band, raising the rate for fixed-rate operations, and reinforcing the fixed-rate operations while eliminating the 10Y yield reference rate.
Market pressure for immediate changes is not particularly compelling. Currently, the 10Y JGB yield stands at 0.9%, still below the 1% ceiling allowed by the BOJ under fixed-rate operations.
Meanwhile, the BOJ recently took actions in July by revising the rate for fixed-rate operations to 1%. Implementing sequential changes within three months could raise expectations for additional adjustments, potentially resulting in undesired market impacts.
Inflation forecasts
Inflation forecasts are poised for an upward revision as the BOJ updates its annual economic forecasts during the October 31 meeting. Our anticipations are that the BOJ will raise the FY23 core CPI forecast to nearly 3% from the current 2.5%, along with an increase in the FY23 core-core CPI forecast to nearly 4% from the current 3.2%. We are also revising our 2023 CPI forecast to 3.2% from 3.0%.
These revisions primarily take into account the sustained impact of high oil prices and a weak yen, factors that are likely to maintain elevated imported inflation for an extended period. The knock-on effect on domestic goods and services prices is also expected to persist.
In terms of the demand-side, underlying inflation, we observe a rising trend, but it has not yet reached the BOJ's 2% target. This is partly due to deep-rooted deflation expectations in Japan over the past decades, resulting in an exceptionally flat Philips curve. Despite the closing of the output gap, it does not necessarily indicate that trend inflation is approaching 2%.
Meanwhile, wage growth falls short of driving sustainable 2% inflation. Recent wage data shows a modest 1.3% YoY increase in total wages from January to August, with a 1.1% rise in base wages during the same period.
In response to the ongoing rise in imported inflation, fiscal measures are anticipated to be deployed instead of monetary ones. A special parliamentary session scheduled from October 20 to December 13 may involve the proposal of a supplementary budget worth JPY 15-20 tn. Part of this budget aims to counteract the impact of rising inflation, which could include measures such as extending gasoline subsidies and providing cash payouts to low-income households.
The BOJ is also poised to make upward revisions to its FY24 inflation forecasts, projecting an inflation rate of around 2%, compared to the current figures of 1.9% for core CPI and 1.7% for core-core CPI. We are also adjusting our 2024 CPI forecast to 2.0% from the previous 1.0%.
These adjustments are not only attributed to the enduring impact of imported inflation but also reflect a slightly more optimistic wage outlook for 2024. RENGO has recently set a target of 5% or higher for the upcoming wage negotiations in the next year, including a base-pay increase of 3% or more. This stance is stronger than their demand for an "around 5%" pay raise at the end of 2022.
Last year's wage negotiation target yielded a 3.7% increase in total wages and a 2.3% increase in base wages during this year's Shunto negotiations. RENGO's more ambitious goal suggests the potential for a 4% increase in overall wages and an approximate 3% increase in base wages during the 2024 Shunto. The BOJ views 3% wage growth as essential to achieving sustainable 2% inflation.
However, it's important to note that macro wage data often lag behind Shunto results. Shunto negotiations do not encompass companies without labor unions or non-regular employees such as part-time and contract workers. Actual wage growth in 2024 may still fall short of the 3% threshold needed to attain sustainable inflation.
YCC or NIRP termination
The likelihood of the BOJ terminating its YCC or the Negative Interest Rate Policy (NIRP) at the upcoming meeting remains low. Policymakers would prefer to wait for the 2024 Shunto results and, importantly, to witness significant improvements in macro wage data to ensure the success of their reflation efforts.
We are tentatively considering a 10bps increase in the policy-balance rate from -0.1% to 0% in 2Q24. The Shunto results will become available in the spring of 2024. Additionally, the BOJ may release the findings of its comprehensive policy review during the Apr-Oct24 period, which could lay the groundwork for policy normalization.
The potential impact of raising the policy-balance rate could be effectively managed. Currently, deposits held at the BOJ earn interest under a "three-tier structure," with the -0.1% interest rate applied to only a portion of BOJ’s current account deposit balances. Raising the policy-balance rate from -0.1% to 0% does not necessarily translate to a 10 bps rise in short-term effective interest rates. The BOJ has the flexibility to adjust the "three-tier structure" to mitigate the potential impact. It can also continue to commit to monetary easing through the maintenance of YCC and QQE.
The BOJ would exercise caution when contemplating the termination of YCC. If long-term JGB yields are determined by market forces and surpass nominal GDP growth, it could weaken the dynamics of public debt. This necessitates careful consideration, particularly given Japan's substantial public debt burdens, the forthcoming LDP leadership election, and the potential general election in 2024.
JPY softness is likely with an unchanged BOJ
With the BOJ set to stand pat in its Oct meeting and both YCC and NIRP likely to be left unchanged, repositioning for carry trades could pressure the JPY lower post-BOJ.
We expect USD/JPY to be buoyed within the 150-152 range if the BOJ maintains a dovish outlook on inflation beyond FY24, tempering speculation of larger policy shifts in the future such as the removal of YCC. Above the 152 level for USD/JPY, our analysis of Japan’s historical market intervention behavior (see JPY and RMB: Rising risks of policy smoothing, 20 Oct) suggests that the risk of official JPY smoothing could become non-trivial. Indeed, our model sees JPY-buying intervention as the most likely outcome if USD/JPY reaches 160. Thus, relatively modest JPY weakness could be tolerated, but not an outsized move.
Equally, ongoing rhetoric from officials indicates a bias toward restraining sharp declines in JPY. Finance Minister Suzuki and Vice Finance Minister Kanda have both stressed this month that they are watching FX moves with a sense of urgency and that excessive JPY volatility is undesirable. Furthermore, Kanda had stated recently that steady, accumulated JPY declines over a protracted period may also be a trigger for policy action, even without abrupt moves and short-term volatility. We advise caution against expecting an extended rise in USD/JPY and favor options to protect against the risk of sudden intervention.
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