Economics Japan: BOJ s exit will take time

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Economics Japan: BOJ s exit will take time DBS Group Research 14 June 2017 The Bank of Japan (BOJ) has been focusing on yield curve control after reforming its policy framework in Sep16 The recent

Hence, the BOJ s exit from stimulus is still distant When the time eventually arrives to do so, expect the BOJ to take a cautious and gradual approach to policy normalisation Debate has started on

1 Economics Japan: BOJ s exit will take time DBS Group Research 14 June 2017 The Bank of Japan (BOJ) has been focusing on yield curve control after reforming its policy framework in Sep16 The recent decline in the quantity of bond purchases does not imply a withdrawal of stimulus Japan s flat Phillips curve still sees the need for a large output gap, which just turned positive, to lift inflation Hence, the BOJ s exit from stimulus is still distant When the time eventually arrives to do so, expect the BOJ to take a cautious and gradual approach to policy normalisation Debate has started on when the Bank of Japan (BOJ) will start to withdraw its massive monetary stimulus. Economic data have been improving across the region including in Japan, thanks to the recovery in trade and manufacturing activities. The US Federal Reserve is poised to accelerate the pace of rate hikes and shrink its balance sheet this year. Barring political risks, the European Central Bank (ECB) is also likely to announce a trimming of asset purchases by the year-end (effective from early 2018). In contrast with the Fed and the ECB, the BOJ may not move to withdraw stimulus anytime soon. The BOJ focuses on yield curve control The BOJ has pursued several rounds of monetary policy easing in the past four years under Abenomics. The Quantitative and Qualitative Easing (QQE) program was launched in Apr13 and expanded in Oct14. A negative Interest Rate Policy (NIRP) was adopted in Jan16, followed by a Yield Curve Control (YCC) policy in Sep16 (Table 1). Under the current YCC framework, the BOJ anchors both the short-term and longterm interest rates. The short-term policy rate interest rate on excess reserves (IOER) has been kept unchanged at -0.1% since it was pushed into the negative territory in Jan16. The long-term rate target 10Y JGB yield has also been maintained at 0% since the YCC was introduced in Sep16. Table 1: The BOJ's monetary policy framework Quantity Quality Yield curve JGBs ETFs REITs IOER 10Y JGB Apr 2013 JPY 60-trn 7 years JPY 1trn JPY 30bn Oct 2014 JPY trn 7-10 years JPY 3trn JPY bn Dec 2015 JPY trn 7-12 years JPY 3.3trn JPY bn Jan 2016 JPY trn 7-12 years JPY 3.3trn JPY bn -0.10% Jul 2016 JPY trn 7-12 years JPY 6trn JPY bn -0.10% Sep 2016 More or less JPY trn Abolished the guideline JPY 6trn JPY bn -0.10% Around 0% Ma Tieying (65) matieying@dbs.com Refer to important disclosures at the end of this report. 1

2 Chart 1: Base money growth YoY, JPY trn 60 QQE2 (Oct14) NIRP (Jan16) YCC (Sep16) Chart 2: JGB yields % pa Y 5Y 10Y QQE1 (Apr13) Jan-13 Jan-14 Jan-15 Jan-16 Jan Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Unlike the start of QQE, the BOJ no longer sets a concrete asset purchases target. In buying JGBs around (and not at) the current pace of JPY trn per year, the growth in monetary base has started to fluctuate. For example, in the YoY terms, base money growth slowed to JPY 74trn in Sep-Oct16, rebounded to JPY 78trn in Nov16-Jan17 before they fell to JPY 73trn in Feb-May17 (Chart 1). The quantity of bond purchases has declined notably recently More recently, bond purchases appeared to have declined further. From March, the BOJ has started to announce the specific range of bond purchases during the monthly regular operations (Table 2). As inferred from the mid-point of the scheduled range, bond buying fell notably from April to an equivalent of JPY 50-60trn a year. Expect base money (YoY) growth to keep slowing in the months ahead. The reduction in bond purchases, however, may not imply a withdrawal of stimulus. It is important to note that the yield curve has been well anchored. The actual 10Y yield stayed fairly close to the target level of 0% over the past eight months, in the range of -0.1% to 0.1% (Chart 2). The BOJ stepped up JGB buying to cap the 10Y yield at 0.1% when global yields surged after the US presidential election last November. It subsequently scaled back JGB purchases when global yields retreated this year on Trump s stimulus plans going off track. The reduction was concentrated in the 1-5Y space where yields had fallen excessively since the introduction of the NIRP last year and stayed below the IOER of -0.1% (also Table 2). Given the volatile market environment, the BOJ will likely continue to conduct bond operations in a flexible manner going forward. A rebound in JGB yields, e.g., due to the spillover effects from Fed tightening and ECB tapering expectations, would prompt the BOJ to increase bond purchases again in 2H17. As the quantity of purchases fluctuates in a wider range, the BOJ may eventually remove from its statement, its commitment to buy JGBs around the pace of JPY trn a year. Table 2: The BOJ's schedule of monthly JGB purchases Purchases per auction (JPY bn) <1 year 1-3 year 3-5 year 5-10 year year >25 year Mar Apr May Jun Number of auctions

3 Chart 3: The Phillips curve Core CPI inflation (VAT adjusted), % YoY Output gap, % of GDP y = 0.28x y = x Inflation outlook remains key The inflation outlook remains the key factor dictating monetary policy. Four years ago, when the BOJ introduced the QQE in Apr 2013, its primary aim was to create inflation expectations and to correct the deflation mindset among Japanese consumers and businesses. The central bank understands that the Phillips curve is extremely flat in Japan due to deeply-rooted deflation over the past two decades (Chart 3). Having a slightly positive output gap is not enough to achieve inflation in a stable manner. As such, the BOJ wants to shift the Phillips curve upward through directly boosting inflation expectations. Indeed, inflation expectations rose under the QQE, but only temporarily. According to the consumer confidence surveys, the percentage of people expecting prices to go up in the next 12 months jumped to more than % immediately after QQE started in Apr 2013, and rose further to nearly % in late Unfortunately, these expectations peaked in 2014, and have since late 2015, retreated sharply to -% these days (Chart 4). Likewise, inflation expectations in the corporate sector rose temporarily as a result of QQE. In the Tankan business survey, the expected inflation rate for the next one year surged to 1.5% during the initial stage of QQE. But this has come down sharply since 2H15, to just 0.7% nowadays (Chart 5). Chart 4: Consumers' inflation expectations % Chart 5: Enterprises' inflation expectations % % of consumers expecting prices to go up in the next 1 year 55 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan General prices: 1 year ahead 3 years ahead 5 years ahead 1Q14 1Q15 1Q16 1Q17 3

4 Chart 6: USD/JPY vs. UST yield 130 % pa 3.00 Chart 7: Output gap vs. inflation % of GDP 6 2q lag, % YoY USD/JPY 10Y UST yield (RHS) Jan-12 Jan-14 Jan Output gap (DBS) -6 Output gap (BOJ) -8 Core CPI (RHS) 1Q94 1Q98 1Q02 1Q06 1Q10 1Q The aggressive scale of QQE in 2013 shocked the financial markets and weakened the yen by some 25%, which in turn, boosted import prices and thus inflation expectations. The second-round of QQE in 2014 continued to weaken the yen, but the inflationary impact was offset by the collapse in global oil prices and the contraction in domestic demand after the sales tax hike. During the subsequent moves to ease monetary policy, the positive effects on the financial markets / public expectations were insignificant. The NIRP introduced in 2016 led to some panic in the markets and brought about yen appreciation instead of depreciation. While there was no excitement over its announcement, the arrival of the YCC policy last year increased the correlation between USD/JPY and the UST yields in the past eight months (Chart 6). Weak inflation will continue to challenge the BOJ As inflation expectations remained weak, the shape of the Phillips curve has not changed substantially compared to four years ago. Throughout the period of QQE in , the flat curve implied that a very large output gap is still needed to generate core inflation (also Chart 3). To achieve the BOJ s 2% inflation target, we reckon that a 3% output gap will be needed. Realistically, this will be hard to attain because GDP growth needs to rise to about 4%. According to the BOJ s estimate (supply-side approach), the output gap has just turned positive since 3Q16 and widened slightly to 0.6% of GDP as of 4Q16. Our estimate, based on a simple HP filter method, shows an output gap of 0.1% in 1Q17 (after taking into account the downward revision in 1Q17 GDP). In either case, the output gap remains very small currently and will push up inflation only slightly in two quarters time, to about 0.5% in 2H17 (Chart 7). Even if GDP growth accelerates to 2% and takes the output gap to 1% by the end of this year, inflation will only be a tad higher next year, reaching 0.8% by mid A weak inflation outlook will likely continue to challenge the BOJ and discourage it from rolling back stimulus. The early steps of policy normalisation hikes in the 10Y yield target and the IOER would only come in a modest and gradual manner when needed in future. Moves like removing the guidance on the yield curve and unwinding the balance sheet still appear remote. Sources: All data are sourced from CEIC, Bloomberg and BOJ. Transformations and forecasts are from DBS Group Research. 4

5 Recent Research Qtrly: Economics-Markets-Strategy 3Q17 8 Jun 17 Global: on sentiment, cycles and 60-year 1 Jun 17 track records EZ: ECB not ready yet 23 May 17 CN: reality check 16 May 17 IN: RBI on the defensive 16 May 17 KR: after the election 12 May 17 US: unwinding QE 4 May 17 FX: USD s hopes Trumpled 3 May 17 IN: time for an upgrade? 28 Apr 17 Rates: global rates roundup 25 Apr 17 TW: Trump and Taiwan, revisited 20 Apr 17 ID: stronger rupiah a boost 20 Apr 17 CNH: room to loosen controls 13 Apr 17 IN: watching state finances 12 Apr 17 SGD: neutral for a long time to come 7 Apr 17 SGS: FX tailwind at the limit 7 Apr 17 IN: structural tailwinds to add to cyclical 31 Mar 17 upswing KR: is optimism justified? 29 Mar 17 IN: monetary policy on cruise control 27 Mar 17 TH: narrower C/A surplus a plus 21 Mar 17 SG: ensuring fiscal sustainability 20 Mar 17 Qtrly: Economics-Markets-Strategy 2Q17 9 Mar 17 Asia: Trump and the state of US-Asia trade 7 Mar 17 CN: the rise and rise (and rise) of the RMB 24 Feb 17 ID: next move is a rate hike 21 Feb 17 SG budget: building the future economy 21 Feb 17 CN: what to watch for as PBoC tightens 20 Feb 17 SG: upgraded 20 Feb 17 TW: Trump s policies and Taiwan 15 Feb 17 SG: shaping the future 6 Feb 17 FX: USD strength hits a roadblock 3 Feb 17 IN budget: a balanced approach 2 Feb 17 Rates: global rates roundup 2 Feb 17 TW: shifting into higher gear 27 Jan 17 SG: time to recalibrate 26 Jan 17 EZ: ECB stays defensive 24 Jan 17 ID: looking at an S&P upgrade 19 Jan 17 US: pop goes the headline 18 Jan 17 Asia cyclical dashboard 17 Jan 17 IN budget: stability over growth 12 Jan 17 Rates: SGS: US-dependent 10 Jan 17 IN: is oil the next headache? 13 Dec 16 Qtrly: Economics-Markets-Strategy 1Q17 8 Dec 16 ID: FDI much stronger than it appears 30 Nov 16 EZ: ECB challenged by higher bond yields 16 Nov 16 TW: 7 likely outcomes in Nov 16 Global: revenge of the demographic dividend 14 Nov 16 Disclaimer: The information herein is published by DBS Bank Ltd (the Company ). It is based on information obtained from sources believed to be reliable, but the Company does not make any representation or warranty, express or implied, as to its accuracy, completeness, timeliness or correctness for any particular purpose. Opinions expressed are subject to change without notice. Any recommendation contained herein does not have regard to the specific investment objectives, financial situation and the particular needs of any specific addressee. The information herein is published for the information of addressees only and is not to be taken in substitution for the exercise of judgement by addressees, who should obtain separate legal or financial advice. The Company, or any of its related companies or any individuals connected with the group accepts no liability for any direct, special, indirect, consequential, incidental damages or any other loss or damages of any kind arising from any use of the information herein (including any error, omission or misstatement herein, negligent or otherwise) or further communication thereof, even if the Company or any other person has been advised of the possibility thereof. The information herein is not to be construed as an offer or a solicitation of an offer to buy or sell any securities, futures, options or other financial instruments or to provide any investment advice or services. The Company and its associates, their directors, officers and/or employees may have positions or other interests in, and may effect transactions in securities mentioned herein and may also perform or seek to perform broking, investment banking and other banking or financial services for these companies. The information herein is not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation. Sources for all charts and tables are CEIC and Bloomberg unless otherwise specified. DBS Bank Ltd., 12 Marina Blvd, Marina Bay Financial Center Tower 3, Singapore Tel: Company Registration No E. 5

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