Central Banks

This time, Japan keen to learn from Fed's policy exit

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As markets tune into how the Federal Reserve is going to rein in its massive stimulus program, so is the Bank of Japan.

The BOJ, the pioneer of so-called quantitative easing, is still years away from tapering off its own extraordinary stimulus program so it has the luxury of watching the U.S. central bank go first.

But the more that the BOJ is able to push inflation towards its policy target of 2 percent - compared with less than 1 percent now and following years of deflation - the more attention financial markets will pay to how Japan's exit debate is shaping up. For now, all eyes are on the Fed.

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It is widely expected this week to announce a trimming of its $85 billion bond-buying program, a delicate operation of communicating its plans to fickle investors without causing financial market turmoil. Those market expectations have already led to an emerging market rout this year.

"The difficulty of exit is already proven by the Fed," said a source familiar with BOJ thinking. "Just hinting about tapering has jolted markets, probably much more than the Fed had thought."

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So the BOJ plans to learn as much as it can from its U.S. counterpart although internal discussions among policymakers are underway on Japan's own exit strategy.

Indeed, conversations with former and incumbent central bankers, as well as sources familiar with the BOJ's thinking, suggest Japan's exit strategy will resemble the Fed's plan.

Stage one

The BOJ will first start slowing bond purchases from the current pace of roughly 7 trillion yen ($70 billion) per month.

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It will taper gradually in several stages to minimize the impact on markets. At some point, the bond purchases will stop.

The BOJ may then raise the 0.1 percent floor it currently sets on money market rates and revert back to a policy targeting interest rates, which was replaced by one targeting base money in April.

While this approach has broad consensus on the BOJ board, the sticking point is on the timing. Disagreements are already present, providing a window into what may shape the BOJ's ultimate exit strategy in coming years.

Theoretically, the BOJ might start tapering in 2015 if it meets its pledge of achieving 2 percent inflation in two years.

Given the slow pace of price growth in Japan though, the sources say a more realistic start date is 2016 at the earliest.

With a new governor at the helm, the BOJ pledged in April to maintain an aggressive stimulus campaign until 2 percent inflation is "stably maintained."

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That is meant to say the stimulus program is open-ended, BOJ officials have said. So if inflation does not reach 2 percent in the two-year time frame, the BOJ would keep pumping more money into the economy until price growth, on average, reaches that level.

Mandated by Prime Minister Shinzo Abe to pull Japan out of deflation, BOJ Governor Haruhiko Kuroda may prefer to wait for as long as necessary to ensure 2 percent inflation is sustained.

That may mean keeping the stimulus program intact well beyond 2016.


But some policymakers see risks in waiting that long.

Board member Takahide Kiuchi has warned of the drawbacks of maintaining ultra-loose policy for too long, such as sowing the seeds of an asset price bubble. He wants to set a two-year limit for the current aggressive policy and after that, fine-tune the program based on economic conditions.

Another policymaker, Takehiro Sato, also wants a more flexible approach. His comments suggest he sees the possibility of the BOJ tapering its stimulus earlier rather than later.

The former bond market strategist argues the BOJ's price target should be considered as a range surrounding 2 percent and that as long as inflation heads towards that level, the BOJ's mandate would have been fulfilled.

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"If our price goal is considered a flexible framework allowing for a certain allowance, the target is reasonable and achievable," he said in a speech in July.

For now, the central bank is deliberately reticent and vague about an exit strategy to avoid diluting its key message that its priority is to beat deflation, analysts say.

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"The BOJ doesn't see the need now to talk about what it will do with its stimulus program after two years," said Hideo Kumano, chief economist at Dai-ichi Life Research Institute, in Tokyo.

"But if Japan's economy remains in good shape around the time the Fed finishes tapering mid-next year, markets might start talking about who's next and what the BOJ might do about its enormous balance sheet," said Kumano, a former BOJ official.

Learning from Fed

The BOJ is the one central bank in the world with experience of exiting quantitative easing after it adopted a QE policy between 2001 and 2006.

But BOJ officials admit exiting this time will take time and be far more challenging.

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During its previous QE campaign, the BOJ pumped money into the economy mainly by buying short-term securities, which fell off its balance sheet quickly as they matured. It only took four months to withdraw from the stimulus program and start to raise rates from zero.

Under its current program, the BOJ will amass 190 trillion yen ($1.9 trillion) in long-term government bonds by the end of 2014 with maturities of up to 40 years.

It would also have loaded up on nearly 4 trillion yen in riskier assets, such as mutual funds investing in stocks and property.

The BOJ may be forced to sit on a huge pile of assets for years, said Mari Iwashita, chief market economist at SMBC Nikko Securities in Tokyo. The risk will be failing to exit before the economy needs another round of stimulus.

"The BOJ doesn't want to disrupt markets but it also won't want to spend years to taper," said Iwashita, a prominent BOJ watcher. "It may run out of time unless it starts preparing for a tapering around late 2015."

The BOJ's biggest lessons in watching the Fed may be how best to communicate its policy intentions to minimize any shock to markets.

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Once inflation picks up and markets start talking about a BOJ exit, the central bank may adopt "forward guidance" like the Fed and commit to keeping interest rates ultra-low even as it starts slowing asset purchases, sources familiar with BOJ thinking say.

For now, the BOJ is noncommittal.

"We still have time, so we'd like to see through (the Fed's) process a bit longer and learn from how the market reacts after some time," board member Koji Ishida said on Wednesday.

"Markets favor rate cuts and don't like rate hikes because many people lose money. Communication with markets therefore isn't a mirror image for when we raise and cut rates. Obviously, tightening will involve much hardship."