Masaaki Shirakawa, governor of the Bank of JapanTORU YAMANAKA/AFP / Getty Images
The Bank of Japan is likely to hold an emergency meeting on Monday to ease monetary policy in response to the yen's strength after Governor Masaaki Shirakawa returned to Tokyo from a trip to the United States earlier than expected.
Sources had told Reuters that the BOJ was expected to hold an extra meeting early in the week to loosen policy as the strong yen threatens Japan's fragile economic recovery. The early return of Shirakawa, who was originally expected to come back on Monday, has increased the chance of a Monday gathering.
The most likely option is to expand a cheap fixed-rate fund supply program put in place in December, said sources familiar with the BOJ's thinking.
But there is a slim possibility the BOJ could opt for more aggressive measures, such as increasing its government bond purchases or cutting its overnight call rate target, as some government officials are already complaining that minor tweaks to the fund supply scheme would not be enough.
The BOJ has been considering easing policy, but had initially hoped to wait until its Sept. 6-7 rate review for more evidence of the harm the strong yen was inflicting on business sentiment.
But the yen's climb to a fresh 15-year high on the dollar last week and a slide in stock prices have alarmed some in the BOJ into considering action. The BOJ has also been under increasing government pressure to ease policy.
Following are some policy options for the BOJ:
EXPAND FUND SUPPLY TOOL
Possibility: Most likely
The BOJ set up a funding scheme in December that it expanded in March, which offered up to 20 trillion yen ($234-billion) in three-month loans at 0.1 per cent. The decision to set up the scheme was made at an emergency meeting held a day before Shirakawa met with then-Prime Minister Yukio Hatoyama.
That failed to boost bank lending, which marked its eighth straight month of annual falls in July. But it helped to push the yen further away from a November high.
Increasing the amount of funds available, or extending the duration of loans to six months, could push down interbank lending rates and indirectly weaken the yen, analysts say.
Skeptics at the BOJ argue that the yen's drivers are different now than they were in December. Investors now view the yen more as a safe haven and are not focusing on short-term interest rate differentials like they were in December. Therefore, lowering money market rates this time might not have the impact it had in December.
"It's an option but it won't work both in terms of affecting currency moves and supporting the economy," said a source familiar with the BOJ's thinking.
Still, it is among the favoured options within the BOJ as it is easier to implement than other more aggressive measures.
The move would be more of a token gesture to show the central bank was doing what it could to support the economy.
Market reaction: It would have little impact on money market rates and the yen, as such a move is already widely expected in the markets.
BUY MORE GOVERNMENT BONDS, ASSETS
Possibility: Less Likely
This is a less attractive option for the BOJ, which worries that increasing government bond purchases from current levels of 21.6 trillion yen per year could give the impression it was directly financing government spending.
But it would surprise markets and please the government, which may not be satisfied with the widely expected move of expanding the BOJ's fund supply scheme.
Although 10-year bond yields have already dipped below 1.0 per cent, buying more bonds could be a more effective way to support growth as long-term yields still have room to fall.
Additional buying could also weaken the yen by showing markets its determination to expand fund supply, analysts say.
Market reaction: Bond yields might briefly fall, subsequently pushing down the yen. But there could be a danger of yields rising if markets felt Japan was losing control over its debt.
STRENGTHEN COMMITMENT TO EASY POLICY
Possibility: Unlikely
If the government steps up pressure on the BOJ to ease policy further it may cave in to lawmakers' calls to set a more rigid inflation target and commit itself to do more to beat deflation.
But this is unlikely for now, as Shirakawa is against setting a strict price target for fear of binding future monetary policy, BOJ officials say.
The BOJ may instead opt for a vaguer commitment, such as pledging to keep rates low until Japan is comfortably out of deflation. The Federal Reserve's stated commitment to keep rates low for an "extended period" could be an example, analysts say.
The challenge would be to make the pledge clear enough to be effective but vague enough to leave policy options open.
Market reaction: Two-year bond yields, most sensitive to monetary policy, might fall. But the move could be short-lived as such a commitment is effective when markets are starting to factor in the chance of a rate hike, which is not the case now.
REVERT TO QUANTITATIVE EASING, ZERO RATES
Possibility: Highly unlikely
The BOJ already floods markets with cash as it did during its five-year quantitative easing policy until 2006. It now targets interest rates, whereas under its quantitative easing policy it targeted liquidity.
But it is strongly against reverting to a formal quantitative easing policy with a liquidity target, as it feels the policy did little to boost the economy or beat deflation.
Achieving a liquidity target would also be tougher now as banks are in less need of funds than they were a decade ago, when Japan was mired in a severe credit crunch, BOJ officials say.
Cutting the policy rate to zero from 0.1 per cent is also among the least favoured options, as it would discourage banks from trading in the money market and make it hard for the BOJ to guide short-term rates.
But the BOJ may opt to set a range of zero to 0.1 per cent as its new policy target if it feels expanding its fund supply tool could push down overnight rates well below 0.1 per cent.
Market reaction: The shift would come as a surprise and sharply push down money market rates, bond yields and the yen.
Reuters