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Bank of Japan faces credibility test in telegraphing exit from stimulus

Growing signs of life in Japan's economy have presented its central bank with a fresh communications challenge, pushing it to be clearer with markets on how it might dial back its massive stimulus - even though such action remains a long way off.

[TOKYO] Growing signs of life in Japan's economy have presented its central bank with a fresh communications challenge, pushing it to be clearer with markets on how it might dial back its massive stimulus - even though such action remains a long way off.

The Bank of Japan (BOJ) faces a tricky balancing act, according to people familiar with its policymakers' thinking, as it must convince people it has a credible exit strategy without destabilising the bond market by giving too much away.

"There's no point elaborating on a future exit strategy when inflation remains stuck at zero," said one of the sources. "But it's important for the BOJ to show it isn't without a plan."

Telegraphing an exit is a challenge for any central bank, as seen in the 2013 "taper tantrum" of market volatility that followed hints from the Federal Reserve that its bond-buying programme would slow.

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The task is made all the more difficult for the BOJ, say analysts, because its credibility has already been damaged by the failure to come close to its 2 per cent inflation target despite four years of money printing.

The market impact of miscommunication could also be bigger, with the BOJ's balance sheet having swelled to 90 per cent of Japan's nominal gross domestic product - triple the ratio for the European Central Bank and nearly four times that of the Fed.

Still, the BOJ feels compelled to speak more openly about an exit, say the sources familiar with its thinking, as improvements in the economy - now enjoying its longest period of expansion in a decade - have spurred calls from some ruling party lawmakers for clarity on a future withdrawal of stimulus.

Instead of rebuffing debate of an exit strategy as premature, Governor Haruhiko Kuroda told parliament on May 10 the BOJ may consider publicising calculations on how an exit could affect its financial health.

Deputy Governor Kikuo Iwata, among the most vocal proponents of massive asset purchases, also said on Thursday that raising interest on excess reserves financial institutions park with the BOJ could be among the tools it can use in easing back stimulus. "The priority is to stress the BOJ's ultra-loose policy will remain intact," said another source. "That said, there is room for improvement" in communication beyond repeating that debate about an exit strategy is premature, the source said.

A BOJ spokesman said the central bank had "nothing to add beyond what Governor Kuroda said in public".

The BOJ has no immediate plans to publish numerical estimates on how a future monetary tightening could affect the health of its balance sheet, the sources say.

The central bank aims instead to convince markets it has the means to exit smoothly and reserves set aside to cover any losses it may incur from an abrupt spike in bond yields, without going into details, they say.

This reflects concerns held by many central bankers that revealing too much of a future exit plan could spook markets into thinking a policy shift is imminent.

Talk of an exit strategy could also cast doubt on the BOJ's determination to achieve its price goal, thereby undermining the psychological impact of its stimulus programme, the sources familiar with its thinking say.

But growing concerns at the cost of the BOJ's radical monetary experiment voiced by some politicians and market participants have become hard to ignore, the sources say.

The BOJ already owns 40 per cent of Japan's government bond market, and could face losses on those holdings if its moves to withdraw stimulus prompt a sudden rise in yields.

If it decides to tighten policy, the BOJ would need to guide market short-term rates higher by raising the interest it pays to excess reserves financial institutions park with it.

The cost of this could surpass the feeble interest the BOJ earns from its bond holdings, push its book into the red and hurt market confidence in the currency it prints, said Izuru Kato, chief economist at Totan Research.

Alarmed by such risks, a group of lawmakers from Prime Minister Shinzo Abe's ruling party called in April for more clarity from the BOJ.

"Some may argue that it's premature to discuss an exit strategy," the group, led by former cabinet minister Taro Kono, said in a proposal presented to the government. "But the BOJ must analyse the risks and communicate them to markets." Even if the BOJ seeks to enhance transparency on its exit strategy, there is no guarantee markets will pay heed.

Mr Kuroda deployed its massive asset-buying programme in 2013, promising to achieve 2 per cent inflation in two years. But four years into the programme prices are barely rising.

Few market players share the BOJ's forecast that inflation will hit 2 per cent by around early 2019. Many expect the BOJ's next move to be a withdrawal, not an expansion, of stimulus on the view its massive bond buying is unsustainable - despite repeated assurances by Kuroda that it can keep buying bonds.

Paul Sheard, chief economist at S&P Global, warns of the pitfalls of sending signals about an exit plan when markets remain sceptical the BOJ can achieve its price goal.

"There's a danger if the BOJ behaves like a traditional, forward-looking central bank," he said. "Market players who don't believe the BOJ could achieve its target would take it as evidence it is making a policy error. I think Kuroda understands that. There's no hurry to do anything."