Think of the Bank of Japan as a light aircraft. For five years, it has cruised along at around 30,000ft, far higher than necessary. In March, it declared deflation over and announced it would lower its altitude towards a more normal 6,000ft.
But last month, as its altimeter edged below 13,000ft, the central bank was buffeted by strong winds billowing up from the ground. Embarrassingly, it had to edge back up again as it sought to regain control.
That is a fairly rough metaphor for what the BoJ has faced as it tries to normalise monetary policy after five years of unorthodoxy. Now, instead of targeting liquidity, it has reverted to a standard framework of targeting interest rates.
That is proving easier said than done. Until March, the bank was pumping out liquidity of more than Y30,000bn ($264bn, €207bn, £142bn). That compared with the roughly Y6,000bn it estimated was needed to keep overnight rates pegged at “effectively zero”, its new monetary target. Yet, for reasons not perfectly understood, Y6,000bn does not seem to be nearly enough. As the BoJ dipped below Y13,000bn two weeks ago, the overnight call rate – at which banks borrow from each other – flickered into life, jumping to 0.1 per cent.
That may not sound like much. But compared with the 0.001 per cent at which money has been available under deflation, it is positively exorbitant.
To get the rate down, the BoJ has had to inject emergency funds – increasing liquidity – and allow banks to borrow money overnight at 0.1 per cent from a special window at the bank known as the Lombard facility.
Clearly, until a few days ago at least, the bank had not gained full control over its new policy target.
Toshihiko Fukui, BoJ governor, admitted as much, saying: “I am not sure whether we can reduce the balance to required-reserve levels of Y6,000bn over a short period of time.” Just two weeks earlier, according to the Nikkei newspaper, he had said: “We will pursue a process under which the balance is slashed to Y6,000bn-Y7,000bn.”
To be fair, in the past few days there have been strong signs that the bank has got the situation under control. On Tuesday, the average overnight call rate fell to a very low 0.006 per cent, even as liquidity had been trimmed to Y12,400bn.
BoJ officials had long predicted there could be teething problems as it tried to revive a long moribund interbank market. For five years, banks have been drinking at the BoJ fountain. Now that liquidity is being drained, they are having to borrow from each other.
The fact that liquidity has been brought down so fast that overnight rates are already stirring has led some to conclude the BoJ will raise its interest-rate target faster than expected. The betting on when the bank will make its first ¼-point rise has inched forward from October to July.
Yet in recent days, any suggestion that the bank could jump the gun even sooner, by raising rates at its policy board meeting next week, have been more or less quashed. Several board members, including the governor, have played down any such suggestion.
Hidehiko Haru, in a speech last week, said: “The current situation is such that we do not need to make a judgment in haste, and we can act with some latitude.”
In any case, conditions look less favourable for an increase, especially when politicians stand ready to pounce on any blunder. The stock market has fallen to six-month lows and the yen has strengthened, partly on expectations that the BoJ will raise rates three times before next March.
Teizo Taya, special counsellor to the Daiwa Institute and a former BoJ board member, says the bank cannot be sure it has yet reached the true level of liquidity needed to push rates to zero. Much of the turbulence of recent days looks like temporary cross-winds, not evidence that Y13,000bn of liquidity – roughly double previous estimates – is really required to keep rates dormant.
If the bank raised interest rates when there was too much liquidity sloshing around, overnight rates might drop below the bank’s target, causing embarrassment. The implication is that far from hastening a rate rise, recent turbulence on the money market might prolong it. Until its altimeter is working properly, the BoJ will not want to risk any tricky manoeuvres.
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