The Bank of Japan’s recent policy evolution clearly shows that policymakers are running out of options according to Deutsche Bank’s Foreign Exchange Economic’s analyst George Saravelos.

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In a report issued to Deutsche Bank’s clients and reviewed by ValueWalk, Saravelos writes that the BoJ’s decision to raise its inflation target beyond 2% and shift from targeting the quantity to the price of money all along the yield curve, reflects a seismic shift in policy at the bank. Unfortunately, this policy change has sent a signal to the markets that the BoJ is running out of options, rather than a proactive shift to new easing — a signal the bank would have preferred to send to financial markets.

The BoJ is running out of options

Saravelos concludes that the BoJ’s shrinking influence and lack of options will lead to further yen strength for three key reasons:

The Bank of Japan is giving up on driving real rates down
By specifically targeting nominal yields the bank is prioritizing financial stability and bank profitability over real rates. In today’s world of record low interest rates, central banks have two opposing constraints: keeping real yields low to help the real economy but keeping nominal yields from falling further because they are damaging banks and credit creation.

Policy could lead to a self-fulfilling tightening
The Bank of Japan is relinquishing control of real rates by targeting nominal rates, creating a highly pro-cyclical policy asymmetry. A negative demand shock could raise demand for Japanese government bonds and depresses inflation expectations. In this scenario, the BoJ will end up reducing the amount of JGBs it buys and raising real rates. However, on the other hand, if a huge fiscal stimulus from the government put upward pressure on yields the BoJ would effectively monetize the debt raising inflation expectations even further.

Government invitation for helicopter money
In the past, yield targets have been put in place on sovereign bonds to help finance excessive, one-off spending plans such as wars. By adopting a yield target, the central bank is indirectly funding Treasuries, another form of “helicopter money.” By targeting a specific JGB yield, the BoJ is indirectly shifting the onus of a “helicopter drop” to the government. Although Deutsche’s analyst believes that until we see more convincing signs of a substantial and credible fiscal easing from the government, the BoJ’s inflation target will lack credibility.

The BoJ’s policy shift surprised the market initially, but the bank is beginning to lose credibility. Soon after the policy change announcement, the yen gave up most of its gains and started to strengthen, which really shows how little the market trusts the BoJ to hit its targets or reverse the economic stagnation that has plagued Japan for the last two decades.