BOJ Desires That Markets Be Prepared For a Policy Transition, But Not So Quickly

Governor Kazuo Ueda of the Bank of Japan has already taken the markets by surprise twice in less than a year with remarks regarding the future of policy. The most recent instance occurred last week, when bond yields and the yen surged on anticipations of a near-term rate shift.

Over sixteen years have passed since Japan's last interest rate rise, and in that time, financial markets have become extremely sensitive to any indication that ultra-loose monetary conditions may be ending. As a result, the Bank of Japan (BOJ) faces challenges in signaling changes to the markets without inciting destabilizing spikes in bond yields.

However, as the economic argument for abandoning accommodating policy strengthens, the BOJ is more concerned than ever before with avoiding market surprises, according to three sources with knowledge of its thinking. In contrast to his predecessor, who caused market disruptions through sudden changes in policy, Ueda will therefore attempt to provide indications beforehand.

One of the sources expressed the view that surprising markets is not a smart idea, particularly at a time when central banks are reducing stimulus. Another source concurred with this assessment.

This increases the significance of Ueda's remarks at his news conference following the BOJ's two-day meeting that concluded on Tuesday, during which the board was observed to have made minimal adjustments to its ultra-lax policy setting.

A November Reuters survey of economists revealed that over 80% anticipate the BOJ to terminate its negative rate policy within the following year, with half of them pessimistic that it will occur in April. Some believe that a policy transition is possible in January.

It is a delicate balancing act for Ueda. Having allowed inflation to surpass its target of 2% for more than a year, the BOJ wishes to maintain market anticipation of a change in the near future.

However, the BOJ must also refrain from using explicit language or cues that bind it to a particular time, which necessitates the maintenance of some ambiguity in its communications.

According to sources, the BOJ's current strategy is to emphasize the prerequisites for an exit while delaying the pre-announcement of the anticipated timetable.

Certain analysts assert that due to the delicate challenge of communicating without committing, Ueda may provide a variety of ambiguous statements that are susceptible to misinterpretation and unwelcome market volatility.

According to the sources, a more transparent method of communication would be to modify or abandon dovish forward guidance on policy that pledges to increase stimulus as necessary; however, many BOJ members rule out this option due to the unpredictability of the economic outlook.

A further impediment to the BOJ's communication is the incongruity between its dovish policy inclination and its hawkish inflation forecasts, which indicate that the rate will remain close to 2% until early 2026.

Ueda, who attributed the inflation overshoot to cost-push pressures, has emphasized the importance of delaying policy normalization until inflation is primarily driven by domestic demand and stronger wage growth.

However, the governor acknowledged that this was difficult to promote, stating to parliament last week that it was "difficult to provide a convincing explanation for everything."

Mistakes in messaging not only contribute to market volatility but also erode the efficacy of central bank communication, which is a critical component of the policy transmission process.

Senior market economist at Mitsubishi UFJ Morgan Stanley Securities Naomi Muguruma intends to analyze Ueda's assessment of the BOJ's price outlook scrutiny progress.

"The key is how much the BOJ will try to signal the chance of a policy change in January," according to her. "In any case, markets will probably remain volatile given the risk of Ueda's comments being taken out of context again."