BoJ: Economic implications of the new regime – Goldman Sachs

Research Team at Goldman Sachs, notes that the Bank of Japan (BoJ) announced two major changes to its monetary policy framework last week with first being, the BoJ adopted a “yield curve control” framework with a target for the 10-year JGB yield of 0% while the second being that BoJ officials announced that they now aim to let inflation overshoot the 2% target.

Key Quotes

“We use our macro model of the Japanese economy to explore the economic implications of this new regime. Specifically, we compare model simulations of the “old regime” (in which QE runs at the announced rate and the 10-year yield varies freely) with a yield curve control regime (in which both the policy and 10- year yield follow a rule and QE varies freely). We derive three main results.

First, the new framework is unlikely to boost the economy much by itself. This is because the new regime primarily changes the implementation of monetary policy rather than the degree of stimulus provided. A larger boost to the economy would require inflation expectations to be forward-looking and investors to see the overshooting commitment as credible. But neither appears to be the case.

Second, the new regime should amplify the economic benefits of positive domestic shocks. For example, we show that a long-term yield target makes fiscal stimulus more powerful by suppressing the upward pressure on interest rates that would occur under the old regime.

Third, the new regime should also allow Japan to benefit more clearly from a pickup in global growth and/or an increase in global interest rates. A Fed rate hike, for example, should result in greater interest rate divergence than under the old regime, depreciate the Yen more, and generate a bigger net easing in Japanese financial conditions.

The BoJ’s new framework also carries a number of risks. First, a yield curve target might likewise amplify negative shocks to the economy, unless the BoJ decides to effectively implement a yield cap rather than a symmetric target. Second, the new framework might necessitate very large (and potentially infinite) JGB purchases. Third, a permanent long-term yield target could encourage “fiscal dominance” and debt unsustainability.”