Bank of Japan surprises markets with inaction

The Bank of Japan’s regular policy meeting ended in Tokyo on Thursday with the policy committee deciding to take no action.

In the event, this was a major surprise. In recent weeks the consensus expectation had formed solidly behind the view that the central bank would extend its negative interest rate policy which was introduced in January, and also extend the asset purchase programme. However, today’s decision seems to imply that the policy committee feels more time is needed to judge the impact of the most recent changes before extending policy further.

Inflation slowdown

The decision was particularly surprising as the latest inflation data, which was also released today, showed a marked slowdown in progress towards the central bank’s own inflation target of 2%. Indeed, in its statement today the committee implicitly extended the deadline to reach that 2% target into the latter part of 2017. This admission that the target has become harder, without any additional policy response, led to an immediate decline of around 4% in the stockmarket from the levels seen in the morning session. At the same time there was a sharp strengthening of the yen as currency markets priced-in the effective change in expected interest rate differentials.

Some of the current deflationary impact is clearly due to external forces, including the weakness in the price of oil which forms a major part of Japan’s imports. Nevertheless, financial markets had already reflected the change in expectations with the implied inflation rate in index-linked bonds declining this year from around 0.8% to 0.3%. Most surveys of individual consumers in Japan also suggest that the gradual increase in inflationary expectations which has been generated in the last three years has begun to tail-off.

Inconsistency introduces uncertainty

Regardless of the actual level of interest rates or details of policy, the main issue around today’s decision is one of inconsistency. Although Governor Kuroda has successfully surprised investors with the timing of previous decisions, the direction of his policy has always been absolutely clear. As a result, most investors have been prepared to accept his assertion that he would do “whatever it takes” to raise inflationary expectations. With those inflationary expectations now in decline, the lack of response today introduces an element of uncertainty which the financial markets may view negatively. Of course, the central bank’s policy objective is to influence the real economy, not the stockmarket, and we must wait longer to see if the current policy is indeed sufficient to maintain the positive underlying trends we have seen so far.