Explainer-What will BOJ’s quantitative tightening look like?

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The Bank of Japan (BOJ) is expected to provide guidance on its plans to reduce its $5-trillion balance sheet at its upcoming policy meeting. This marks a gradual retreat from the BOJ’s extensive monetary stimulus measures. The central bank may adopt a quantitative tightening (QT) approach to scale back its balance sheet, which has become almost 1.3 times the size of Japan’s economy due to years of aggressive monetary easing.

Currently, the BOJ’s plan and communication involve purchasing approximately 6 trillion yen ($38 billion) of government bonds per month. This is done to prevent a sudden surge in bond yields following the end of negative interest rates and bond yield control in March. BOJ Governor Kazuo Ueda has stated that the bank will eventually reduce bond purchases, but has not provided any indication of the timing for such a move.
The board discussed the topic in April, with some members suggesting the need to decrease the bank’s balance sheet by reducing monthly bond purchases or laying out a future plan.

What decision might the BOJ make on Friday?

According to sources, the BOJ will discuss whether to taper, but the final decision will depend on market developments leading up to the meeting, including the outcome of the U.S. Federal Reserve’s policy meeting on Wednesday.

Considering that Japanese bond yields are stable and the yen remains weak, the BOJ might decide to slightly reduce monthly purchases from 6 trillion yen or lower the range of purchases each month.

However, due to opposition from some board members regarding an early taper, the central bank may opt to provide vague language committing to future reductions in bond purchases. Such commitments could be included in the BOJ’s policy statement or in comments made by Ueda during his post-meeting briefing.

What is at stake?
The Bank of Japan (BOJ) plans to gradually raise short-term interest rates in order to manage inflation, which has exceeded its 2% target. Analysts speculate that the target range for rates will be somewhere between 1-2%, requiring multiple rate hikes over the next few years from the current range of 0-0.1%.

In addition to raising rates, the BOJ also needs to reduce its large balance sheet, which it believes is pushing down long-term borrowing costs by approximately 1%. This reduction is necessary to ensure that future rate hikes effectively reduce the level of monetary support.

However, the BOJ still has a long way to go in reducing its balance sheet. Currently, it stands at 125% of Japan’s gross domestic product (GDP), making it five times larger than the Federal Reserve’s balance sheet in relation to GDP. Therefore, analysts suggest that the BOJ needs to begin tapering its balance sheet sooner rather than later.

There are risks involved in this process. Given Japan’s dire fiscal situation, the BOJ must avoid causing sharp spikes in yields, as this would increase the cost of funding the country’s large public debt.
The BOJ’s long history of intervention in the bond market has led to market participants becoming accustomed to its significant presence. This means that even the slightest signs of tapering could have destabilizing effects on the market.

Unlike the Federal Reserve, which implemented a fixed and predetermined schedule to reduce its balance sheet from a peak of nearly $9 trillion yen to $7.4 trillion as of March, the BOJ will not follow the same approach. Instead, it will continue to provide indications of the amount of bonds it will purchase on a monthly basis and reassure the markets that any tapering will occur gradually. The BOJ will also maintain its pledge to intervene in the market if there are sharp increases in yields.

(Note: The exchange rate is $1 = 156.8400 yen)