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BOJ's move to ease yield curve control points to tricky road ahead

The Bank of Japan's decision Friday to make its yield cap program more flexible may provide the central bank with some room to see if price dynamics are indeed changing and wage growth is continuing to accelerate -- the recipe for finally attaining its 2 percent inflation goal.

Some economists viewed the BOJ's move to allow long-term yields to rise above its ceiling as an "effective scrapping" or "gutting" of its yield curve control program launched in 2016. Others took it as a step toward ending the central bank's ultraeasy monetary policy altogether.

The architect years ago of the central bank's "forward guidance" regarding future monetary policy, Governor Kazuo Ueda has persisted with its stance of maintaining ultralow rates.

The tweak, announced after a two-day policy meeting, would actually boost the effectiveness of monetary easing toward achieving the 2 percent inflation target accompanied by sustainable wage hikes, he said.

Now that the benchmark yield on 10-year government bonds can rise above the existing cap of 0.5 percent toward 1.0 percent, the question is how high -- and how fast -- it will move up and at what point the BOJ will step in to curb it, analysts said.

"This is a de facto abandonment of yield curve control, at least for the time being," said Masamichi Adachi, chief economist for Japan at UBS Securities.

With no guidance introduced for the policy rate, it "suggests that the bank left open the near-term policy rate hike optionality, in our view," he added.

Under the yield curve control program, short-term interest rates are set at minus 0.1 percent while the 10-year yield is guided to around zero percent. The BOJ will try to keep it below 1 percent if needed by carrying out buying at that fixed rate.

Bond yields move inversely to prices. The yield ended Friday at 0.545 percent.

Market players critical of the BOJ's distorting price moves and the International Monetary Fund have been calling for greater flexibility of the 10-year yield. Ueda, who nearly four months ago took over the framework introduced under his predecessor, said he wants yields to more adequately reflect economic fundamentals.

Still, surging yields would deal a further blow to consumers, already reeling from rising prices, because they would have to pay more for mortgages and car loans, hurting household sentiment.

The BOJ's decision spooked financial markets, sending the yen and bond yields surging, while stocks temporarily tumbled in volatile trading. While some market players expected the yield cap program to be modified before the rate review, Ueda himself had acknowledged that tweaking it would come as a "surprise."

Ueda emphasized during a post-meeting press conference that the decision was "future risk management," adding he does not expect the 10-year yield to spike to 1.0 percent.

"We want to make room for the yield to rise above 0.5 percent in case inflation exceeds our current expectations. Why now? That is because the side effects will be far bigger if we move after such upside risks materialize," the governor said.

The BOJ has drawn a sharp contrast with its peers in the United States and Europe, which have been raising interest rates to rein in soaring inflation. The widening interest rate gap has weakened the yen and boosted import costs, a major factor behind the recent cost-push inflation that the BOJ expects to ease further.

Long-term interest rates tend to rise in line with economic growth and accelerating inflation. Until recently, the worry for Japan was the prospect of deflation, or prices falling continuously, and the yield control program was meant to stimulate the economy by keeping rates low.

"The 1.0 percent mark is still far from where the 10-year yield is at present and the BOJ can avoid markets piling pressure to expand the trade band again and again. What it did to the yield curve control program is to gut it," said Mari Iwashita, chief market economist at Daiwa Securities.

"While the BOJ forecasts consumer inflation will ease, I expect the core consumer price index to remain elevated. It won't be until the latter half of next year that the core CPI undershoots 2 percent because companies will pass on more labor and other costs," she added.

During Friday's press conference, Ueda acknowledged that Japan has made "a small step forward" but the 2 percent inflation goal is still far off.

Based on the latest projections, the core CPI excluding volatile fresh food items will rise 2.5 percent in fiscal 2023 but undershoot 2 percent in the following two years.

The BOJ's move may send ripples through global financial markets, with the U.S. Federal Reserve viewed as approaching the end of its aggressive rate hike cycle and the European Central Bank underscoring that any rate increases will be driven by data.

"It may not be so fast but (the dollar) might go down to a level like 125 (yen) by year-end," said Shoki Omori, chief Japan desk strategist at Mizuho Securities, compared with the current level of around 141 yen.

A weak yen cuts both ways for Japan as it boosts exporters' overseas earnings but makes imported goods pricier. Japanese authorities repeatedly intervened in the currency market to arrest the yen's sharp drop last fall.

While the BOJ has emphasized it does not target foreign exchange rates in guiding policy as a principle, Ueda said the latest policy tweak was partly intended to curb market volatility, including forex movements.

"The BOJ doesn't want to be seen as moving toward policy tightening. That being the case, it's gradually setting the stage for yield curve control to be scrapped," said Yuichi Kodama, chief economist at the Meiji Yasuda Research Institute.

"Given the 10-year yield's current level and the strength of the Japanese economy, it can move up to around 0.7 percent but it's hard to expect it to shoot up," Kodama said. "We have yet to see where the BOJ's tolerance level is."