Explanation of Japan’s yield curve control

Explanation of Japan's yield curve control

Bank of Japan

The Challenges and Pitfalls of Japan’s Yield Curve Control

Bank of Japan (BOJ) Governor Kazuo Ueda faces a pressing challenge – to phase out the yield curve control (YCC) policy that has drawn criticism for distorting markets by preventing long-term interest rates from rising1. Despite its shortcomings, YCC was implemented by the BOJ in an attempt to control bond yields and stimulate inflation, but it has faced various pitfalls along the way2. In this article, we will explore the reasons behind the implementation of YCC, how it works, its potential pitfalls, and the future steps the BOJ might take.

Why YCC?

In January 2016, the BOJ resorted to cutting short-term rates below zero to tackle an unwelcome rise in the yen. However, this move resulted in crushing yields across the curve, causing financial institutions to suffer from evaporating returns on investment3. In response, the BOJ introduced YCC eight months later, setting a 0% target for 10-year government bond yields to help control the shape of the yield curve4. The aim was to suppress short- to medium-term rates, which impact corporate borrowers, while avoiding a significant reduction in super-long yields, which would harm pension funds and life insurers5.

How Does it Work?

YCC was chosen as a rate regime when the BOJ realized it had reached the limit of quantitative easing, where it purchased targeted amounts of bonds to lower yields and stimulate inflation6. Implementing YCC allowed the BOJ to only buy as many bonds as necessary to achieve the 0% yield target for 10-year government bonds7. During periods of market calm, the BOJ has tapered bond buying to pave the way for an eventual end to ultra-easy policy8.

The Target Band and Pitfalls

As the BOJ maintained YCC for longer than expected due to persistently low inflation, bond yields began to trade within tight ranges, leading to reduced trading volume9. In response to this, the BOJ widened the target band in both 2018 and 2021 to breathe life back into the market it had previously paralyzed10. Nonetheless, YCC faced criticism for distorting market pricing and contributing to an unwelcome plunge in the yen, which increased the cost of raw material imports11.

What Lies Ahead?

The BOJ intends to avoid raising rates until there is clear evidence of sustainable inflation and higher wage growth, as prematurely dialing back stimulus has historically led to political backlash12. However, the central bank is also keen to avoid a repeat of last year, when it had to ramp up bond buying to defend the yield cap13. Consequently, the BOJ may consider making YCC more sustainable by allowing bond yields to rise flexibly in line with accelerating growth and inflation14. The possibility of briefly breaching the 0.5% cap on the 10-year yield while taking precautions against abrupt yield spikes has been discussed15. This adjustment would ease the BOJ’s reliance on increasing bond purchases and help prevent further declines in the yen16. Nevertheless, it remains uncertain whether the BOJ can successfully loosen its grip on yields without causing significant market volatility17. Ueda is expected to frame any changes to YCC as an effort to make the BOJ’s ultra-loose policy more sustainable, rather than as a precursor to a full-fledged interest rate hike cycle18. However, markets may interpret it differently and begin pricing in the possibility of a gradual normalization of the BOJ’s radical stimulus program19.

In conclusion, Japan’s YCC policy has had both successes and challenges. By understanding the reasons behind its implementation, its workings, and the pitfalls it has faced, we gain insight into the future steps the BOJ might take to adapt and improve its effectiveness. With the guidance of Governor Kazuo Ueda, the BOJ will navigate the path of monetary policy with the intention of promoting sustainable economic growth and stability in Japan.

  1. Source: Reuters↩︎

  2. Source: Reuters↩︎

  3. Source: Reuters↩︎

  4. Source: Reuters↩︎

  5. Source: Reuters↩︎

  6. Source: Reuters↩︎

  7. Source: Reuters↩︎

  8. Source: Reuters↩︎

  9. Source: Reuters↩︎

  10. Source: Reuters↩︎

  11. Source: Reuters↩︎

  12. Source: Reuters↩︎

  13. Source: Reuters↩︎

  14. Source: Reuters↩︎

  15. Source: Reuters↩︎

  16. Source: Reuters↩︎

  17. Source: Reuters↩︎

  18. Source: Reuters↩︎

  19. Source: Reuters↩︎

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