TOKYO (Reuters) - The Bank of Japan ovehauled its monetary policy framework in September, switching to targeting interest rates and the shape of the government bond yield curve from its previous policy of targeting base money.
The BOJ’s new policy has created problems for the central bank in its daily dealings with financial markets, as rising global yields muddle its efforts to manage local rates.
The following is a look at key elements of the policy and the BOJ’s past battles with deflation:
The centrepiece of the BOJ’s monetary policy is controlling the shape of the yield curve, which is formed by plotting yields on government debt with durations from one month out to 40 years.
The BOJ uses the negative 0.1 percent interest rate it charges on a small portion of commercial bank reserves to keep yields low at the short end of the curve.
The BOJ introduced a new target for 10-year government bond yields of around zero percent and will buy government bonds to prevent yields from rising too far above that target.
The BOJ says this is beneficial because it can focus on lowering yields that have the most immediate impact on the economy.
The new policy allows yields on 20-year, 30-year and 40 year debt to rise, which benefits banks and insurers who use a widening spread between short-term and long-yields to generate profits.
Commercial banks had become critical of the BOJ’s monetary policy after a decline in long-term yields caused the curve to flatten so much that their profits started to shrink.
The BOJ does not specify how steep it wants the yield curve to be, only saying that it will aim to guide it to an “desirable shape” reflecting economic fundamentals.
To better control the yield curve, the BOJ introduced a new government debt buying operation. Aside from its regular auctions to buy bonds, it has a new scheme to purchase unlimited amounts of bonds at a set price. This is a last-resort tool in case bond yields spike abruptly.
The BOJ no longer targets the pace of money printing. But it kept intact as a loose goal its previous commitment to buy government debt so the balance of its holdings increase at an annual pace of 80 trillion yen ($700 billion).
BOJ Governor Haruhiko Kuroda has said the central bank could raise or lower the annual rate of purchases in the future depending on the shape of the yield curve.
Some economists said Kuroda had effectively established an easy way to lower debt purchases in the future.
If the BOJ needs to ease policy in the future, the first tools it will use are changes to the negative 0.1 percent interest rate and the target for 10-year government bond yields.
Changes to risk-asset purchases and the annual pace of government bond buying remain options, but Kuroda made it clear the priority had shifted to interest rates.
BOJ officials say the bank would raise its yield targets only when inflation is clearly accelerating toward 2 percent reflecting solid and sustained improvements in the economy.
The BOJ introduced a new commitment to continue expanding the monetary base until core consumer prices rise above its 2 percent inflation target in a stable manner.
Its previous commitment was that it would continue with its stimulus programme until inflation was expected to remain around 2 percent in a stable manner.
Kuroda has said the commitment to overshooting the 2 percent target was intended to dispel speculation that the BOJ had given up on its price target.
However, this commitment may have little impact since many economists have long said 2 percent inflation was overly ambitious goal.
The BOJ became the first major central bank to adopt zero interest rates in 1999 to battle a domestic financial crisis after the burst of an asset-inflated bubble.
It then became the first central bank to adopt quantitative easing (QE), a policy that floods markets with excess cash to reflate the economy, in 2001 to fight deflation.
After ending QE in 2006 and raising its short-term interest rate target up to 0.5 percent in 2007, the BOJ was forced to revert back to zero rates and massive asset purchases when the collapse of Lehman Brothers in 2008 hit the global economy.
It maintained ultra-loose monetary policy but adopted a 2 percent inflation target only in 2013, under intense political pressure to do more to pull the economy out of stagnation.
In April 2013, the BOJ adopted “quantitative and qualitative easing” (QQE) under Kuroda that targets base money and commits to buying assets aggressively until inflation hits 2 percent.
Subdued inflation and a yen spike that hit Japan’s exports forced the BOJ to expand QQE in October 2014 and adopt negative interest rates in January 2015.
($1 = 114.2800 yen)
Reporting by Leika Kihara; Editing by Sam Holmes