The Bank of Japan is poised for another revision of its yield curve control (YCC) framework in response to emerging economic challenges. In a critical monetary policy meeting scheduled for Tuesday, the central bank is considering allowing the yields on 10-year Japanese government bonds to exceed the 1% mark. This move is seen as a necessary response to the increasing pressure on long-term interest rates, driven by the uptick in U.S. rates.

Currently, the Bank of Japan has set a 1% cap on long-term interest rates, employing unlimited fixed-rate purchasing operations to ensure yields remain below this threshold. This policy was introduced in July as a replacement for the previous cap of 0.5%. The rapid shift in the economic landscape necessitates a second adjustment to the YCC framework in just three months.

The decision to revisit the framework appears to be driven by the fact that 10-year yields are approaching the 1% mark. This upward trend is occurring against the backdrop of rising long-term interest rates in the United States, a factor that is influencing the Bank of Japan’s policy considerations.

To address this situation, the Bank of Japan is expected to adopt a more flexible approach to its Japanese government bond (JGB) purchase operations. Additionally, the central bank is contemplating a more adaptable cap on 10-year yields. The objective here is to discourage speculators from targeting the upper limit, thus mitigating the necessity for extensive JGB purchases to maintain rates below 1%.

The recent increase in long-term rates has outpaced the central bank’s initial expectations set in July. As of now, the yield on newly issued 10-year government bonds has reached 0.89%, the highest since July 2013. It is steadily approaching the 1% mark, a threshold that Bank of Japan Governor Kazuo Ueda has referred to as “the upper limit.”

This development is closely linked to the surge in U.S. long-term interest rates. U.S. Federal Reserve Chair Jerome Powell’s announcement on October 19 indicated that further rate hikes could be warranted due to strong economic growth and labor shortages. This statement altered expectations that the Fed would soon halt its rate hikes and temporarily pushed 10-year U.S. Treasuries above 5% for the first time in 16 years.

Another factor influencing the Bank of Japan’s decision is the concern of the Japanese government regarding the depreciation of the yen, as it is contributing to inflationary pressures. The yen recently weakened beyond 150 to the dollar, largely due to the widening interest rate gap between the United States and Japan.

By modifying its YCC framework to permit interest rates to rise to a certain extent, the Bank of Japan could potentially halt the yen’s depreciation, redirecting more funds toward the strengthening U.S. dollar.

However, there are risks associated with making an adjustment to the YCC framework so soon after the previous tweak. If long-term rates were to rise significantly beyond what the Bank of Japan can tolerate, it might necessitate substantial government bond purchases to mitigate the economic impact.

In addition to the YCC framework adjustment, the Bank of Japan will also unveil its policy board members’ median projections for inflation and growth on Tuesday. It is anticipated that the bank will upwardly revise its core Consumer Price Index (CPI) forecast, excluding fresh foods, from the current projection of 2.5% for the fiscal year ending in March 2024, as well as 1.9% for the following fiscal year.

If the CPI outlook approaches the 2% level for fiscal 2024, it would signal a three-year streak of sustained inflation above 2%, bringing the Bank of Japan closer to its goal of achieving stable 2% inflation.

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