Japan's real interest rates show policy is loose, but needs better selling

[TOKYO] As the Bank of Japan considers shifting the focus of monetary policy at next week's review, some analysts say the key will be how well it communicates the intent of the change as further significant easing is not necessary at this stage.

Real interest rates are far lower now than during bouts of deflation in the past - and that is the message the BOJ should focus on selling, some analysts say, before easing further.

Sources familiar with the BOJ's thinking have said negative interest rates could become the centrepiece of monetary policy, shifting away from the base money target that has been the focus of its quantitative and qualitative policy since 2013.

"The key to keeping real rates low and achieving a steeper curve is inflation expectations," said Daiju Aoki, economist at UBS Securities. "The focus of the BOJ's next meeting should be less on additional easing and more on how the BOJ will improve its communications."

Since QQE was launched in April 2013 real rates - the nominal interest rate on 10-tear government bonds less the inflation rate - have averaged minus 0.03 per cent.

By comparison, during Japan's longest bout of deflation from mid-1998 to late 2007, real rates averaged plus 1.8 per cent.

Reuters subtracted the 2014 sales tax hike impact from core CPI and then subtracted core CPI from 10-year bond yields to determine the trend since 1996.

BOJ Governor Haruhiko Kuroda set a target of lifting inflation to 2 per cent in two years as a way of trying to create a perception among the public that prices were set to rise.

The BOJ has linked inflation expectations with annual wage negotiations, capital expenditure and oil prices, none of which rose quickly enough to make people think inflation would get much of a grip, economists say.

Persisting with the inflation target even after the initial two years had passed only seemed to highlight what policy had not achieved.

Households' inflation expectations are now lower than they were before QQE started, consumer sentiment data show.

Core consumer prices, which include energy but exclude fresh food, fell an annual 0.5 per cent in July, the weakest in more than three years, although a BOJ measure of prices showed a rise of 0.5 per cent.

One complication of QQE has been the flattening of the yield curve as a result of the BOJ dominating the market for government bonds (JGBs) through its asset-buying programme.

Nominal yields have fallen so much that banks, insurers and pension funds, which use the spread between short- and long-term yields to generate profits, are losing money. On Friday, the spread between 2-year and 20-year government debt yields was 0.73 per cent, down from 1.33 per cent before quantitative easing.

BOJ officials are leaning toward steepening the curve by buying more shorter-dated debt and letting super-long term government bond yields rise, sources say.

"The BOJ will argue that quantitative easing with negative rates is having an effect, but too much flattening of the yield curve is harmful," said Hiroshi Shiraishi, senior economist at BNP Paribas Securities. "In order to maximise the impact of quantitative easing, government debt purchases need to be flexible."

As well, the government's 13.5 trillion yen stimulus package should help give people confidence that economic growth will be supported in the future.

So if Kuroda can turn inflation expectations into a story about credit growth and fiscal stimulus, he could get a welcome boost, economists say.

"If there is no gross domestic product growth, inflation expectations will not rise continually toward 2 per cent," said Takuji Aida, chief economist at Societe Generale Securities. "Real gross domestic product will be supported by fiscal policy in the short run. I think the BOJ will say coordination with the government is important."

REUTERS