Deutsche Bank Perspectives Global Economic Economicspg.jrj.com.cn/acc/Res/CN_RES/INVEST/2016/9/15/63a0dcef...2016/09/15 · 2 "Quantitative and Qualitative Monetary Easing: Assessment

15 September 2016

Global Economic Perspectives

Deutsche Bank AG/Hong Kong

DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 057/04/2016.

AsiaJapan

Economics

Global EconomicPerspectives

Date15 September 2016

Deutsche BankResearch

The Bank of Japan Reassesses Policy■ The BoJ's Monetary Policy Board meets on Sept 20-21 and will be

presented with a "comprehensive assessment" of the effectiveness ofits policies, which it had in July commissioned the staff to prepare. Weexpect that report to conclude, as did an earlier assessment in 2015, thatasset purchases had been successful in driving down funding costs andpushing growth and inflation higher. We expect they will also concludethat the introduction of negative interest rates in January this year had apowerful complementary effect.

■ The report will likely conclude that exogenous shocks – the decline inenergy prices, slower Chinese growth and weak US and European activity– a larger-than-expected decline in demand after the 2014 consumptiontax increase and strongly backward-looking inflation expectations areresponsible for the failure to meet the 2% inflation target as expected.

■ The most likely course of action for the Board, therefore, will be to leavepolicies unchanged on the basis that as these exogenous effects wearoff inflation and inflation expectations will both rise. Any reduction in thedegree of policy accommodation is extremely unlikely, in our view.

■ But possibly, either next week or later in the year (perhaps October), theBoard will reconfigure policy to gain more flexibility in terms of the paceand types of asset purchases to address concerns about illiquidity atthe long end of the bond market. To prevent this being interpreted as atightening of policy, such a measure would likely be accompanied by a cutin the interest rate on the Policy-Rate Balance of banks' current accounts.

■ To address concerns about the negative impact on bank profitability froma rate cut, this might be combined with either unchanged interest rateson the rest of banks' reserves or a merging of the Basic and Macro Add-On balances at a positive interest rate.

■ A steepening of the yield curve is a likely outcome of such a policypackage. This is especially likely because we think negative rates havenot been as beneficial as the BoJ is likely to conclude. Indeed, we thinkthe introduction of negative interest rates has been counter-productivewith the costs outweighing the benefits, contrary to the Bank's likelyassessment. It would take an implausibly large rate cut to offset theimpact of even a modest reduction in bond purchases, in our view.

Michael Spencer, Ph.D

Chief Economist

+852-2203 8303

Peter Hooper, Ph.D

Chief Economist

+1-212-250-7352

Torsten Slok, Ph.D

Chief Economist

+1-212-250-2155

Matthew Luzzetti, Ph.D

Senior Economist

+1-212-250-6161

Distributed on: 15/09/2016 10:48:09 GMT

15 September 2016


Page 2 Deutsche Bank AG/Hong Kong

Introduction

During its September 20-21 meeting, the Bank of Japan's Monetary Policy Boardwill discuss the results of a "comprehensive assessment" of its quantitative andqualitative easing (QQE) with negative interest rates policy, which in July it haddirected the bank's staff to prepare. The report will focus on the effectiveness ofmonetary policy and the factors that have prevented the Bank from achieving its2% target. The report will also likely confront the question of possible negativeimplications of negative interest rates on market participants, not just banks, andwhether those effects warrant a change in direction for policy.

Our expectation is that the Board will conclude that QQE and negative interestrates would have succeeded in achieving the inflation target by now had it notbeen for negative exogenous shocks – the steep decline in commodity prices,slowing Chinese growth and natural disasters in Japan– and strongly backward-looking inflation expectations that have thwarted the BoJ's forward guidance.

In terms of policy, therefore, we think it is most likely that the Board will keeppolicies unchanged, including the asset purchase program, USD liquidity facilitiesand the interest rate on banks' current account deposits. The logic would be thatas the temporary factors depressing inflation wear off measured inflation will riseand as it does inflation expectations will as well, lowering real interest rates andhelping to boost economic activity and inflation.

The most likely alternative outcome would be some reconfiguration of policy,gaining some flexibility on asset purchases combined with an interest rate cut,possibly modified to reduce the damage to bank profitability. Deputy GovernorNakaso recently stated categorically that a discussion of "reducing the level ofmonetary accommodation will not be on the agenda."1 Specifically, we think theBoard could redefine the asset purchase target in a range – say JPY70-90tn –rather than a hard JPY80tn target (recall the initial QQE program was defined asa range of purchases of JPY60-70tn per year) and cut the interest rate applied tothe Policy Rate Balance of banks' current accounts.

This could have the effect of steepening the yield curve, which would help thebanks out, although we doubt very much that the BoJ would want to see JGByields rise. So they may hope that any appearance of 'tapering' of bond purchasesis offset by the rate cut, leaving bond yields stable and short-term rates lower.We'll argue later that we would expect such a combination to leave JGB yieldssignificantly higher.

Alternatively, or perhaps additionally, the Board could try to prevent furtherdeterioration in banks' earnings by keeping the interest rates on the Basic Balanceand Macro Add-on Balance unchanged (0.1% and 0.0%, respectively) while theycut the rate on the Policy Rate Balance or even merging the latter into the BasicBalance at a positive interest rate.

Communicating such a complicated mix of policy adjustments will be challengingin an environment in which more and more investors think the BoJ is lookingto reduce the level of monetary stimulus out of financial stability concerns: an

1 Nakaso, Hiroshi, "Toward a 'Comprehensive Assessment' of the Monetary Easing", speech at a meetinghosted by the American Chamber of Commerce in Japan (ACCJ) in Tokyo, Sept 8, 2016, p.6

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Deutsche Bank AG/Hong Kong Page 3

increasingly illiquid bond market, negative interest rates impairing the viability offixed income investors and potentially damaging credit intermediation throughnarrower credit spreads. It may be, therefore, that the Board waits until asubsequent meeting, perhaps in October when the Board will update its economicprojections, but an announcement next week – to re-enforce the commitment tothe current policy – can't be ruled out.

Even if the Monetary Policy Board does announce a set of policy adjustmentsthat give the appearance of trying to help out the banks, we think the staff'sassessment will conclude that financial stability concerns, while genuine, aremore than offset by the benefits of negative interest rates and even negativebond yields provided the latter are not maintained indefinitely. Left undefined, weexpect, will be any guidance on how long keeping rates negative would be 'toolong'.

Our "comprehensive assessment" of the BoJ's policy

The Bank of Japan's staff have already gone on record with one assessment ofQQE with a report published, in May 2015.2 That assessment, covering the periodfrom 2013Q1 to 2014Q4, concluded that QQE had lowered real interest rates byslightly less than 1% and had pushed the output gap up (towards full employment)by between 1.1% and 3.0% of GDP and raised inflation by between 0.6% and1.0%. To anticipate perhaps how the staff's report will come out: since the end of2014, we think real interest rates are unchanged and possibly higher. So, whilethe staff will likely conclude that policy continues to support growth and inflation,they may find it difficult to argue that the effectiveness of policy has improvedeven with the introduction of negative interest rates.

Interest rates have fallen but inflation hasn't gotten close to 2%To take a high-level view of things, the objective of QQE with negative ratesis to drive inflation up to a stable 2% rate. We'll define later how we make"stable" an operational concept, but since the main transmission mechanism ofunconventional policy is supposed to be via the downward pressure on nominalbond yields coupled with an intended increase in inflation expectations, weconsider first in the figures below how interest rates and inflation have evolvedsince 2012.3

Initially, the 10yr bond yield rose as markets priced in higher inflationexpectations, but quickly the weight of bond purchases drove yields lower (Figure1). The 10yr yield had fallen from about 0.8% just before QQE was announcedto about 0.3% at the end of 2015. As the chart below amply shows, theannouncement of a negative interest rate on even a small part of banks' reserveson January 29, 2016 had a powerful impact on bond yields: the 10yr yield fell16bps in two days and within a month yields were sustained below zero.

2 "Quantitative and Qualitative Monetary Easing: Assessment of Its Effects in the Two Years since ItsIntroduction," Bank of Japan Review, 2015-E-3, May 2015.

3 QQE is only the latest, albeit most aggressive, form of unconventional monetary policy in Japan. WhenPrime Minister Abe was elected, the BoJ was already two years into an asset purchase program and thecall rate had been lowered to 0.5% in October 2010. Under the QQE program, JGB purchases rose fromJPY24tn a year to JPY50tn and then after October 2014 to JPY80tn.

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Figure 1: Call rate and the 10 yearbond yield

Sources: Haver and Deutsche Bank Research

Figure 2: Headline and 'core core'consumer prices

Sources: Haver and Deutsche Bank Research. Note: Inflationadjusted for the April 2014 consumption tax increase.

Inflation, which was negative through most of 2012 – indeed had been negativefor most of the previous two decades – turned sharply higher by mid-2013 bothat the headline and excluding volatile food and energy prices (Figure 2). With thedecline in oil prices, however, headline inflation in Japan fell back to zero in 2015.But even 'core core' inflation (henceforth just "core") was falling in the second halfof 2014 partly reflecting passthrough from lower oil prices and partly reflectingthe recession that followed the April 2014 consumption tax increase (Figure 3).

Recovery in the economy saw core inflation rise in 2015 even while importeddeflationary pressures kept headline inflation at zero, but since the beginningof this year both headline and core inflation have been falling. Whether at theheadline in 2014 or core levels in 2015, inflation hasn't exceeded 1.5%, far shortof the 2.0% target. The role of commodity prices is clearly evident, though, in thegap between headline and underlying inflation of just over one percentage pointover the past year. If, as we expect, energy prices continue to grind higher, thisgap will likely reverse, taking headline inflation above core. Whether core is anyhigher than it is today remains to be seen.

As much as the BoJ emphasizes the transmission channel through bond yields itseems the channel through the exchange rate has been more important (Figure4). While bond yields have steadily declined, the rise and fall of inflation seemsmore likely to be a reflection of the initial large depreciation of the JPY in 2013and the appreciation over the past year.

Figure 3: GDP growth in Japan


Figure 4: Inflation and the exchangerate


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As tempting as it may be to say that all Japan needs to achieve 2% inflation isan even weaker currency, that doesn't pass the test of a 'stable' rate of inflation,in our view. A persistent trade-weighted depreciation of 20% or more per year isnot an equilibrium, and we think the word 'stable' in the BoJ's inflation target isreference to an equilibrium concept.

To identify what the current equilibrium rate of inflation is, we look to the PhillipsCurve, because we think it may be how the BoJ itself thinks of it. The PhillipsCurve below plots the BoJ's estimate of the output gap, lagged two quarters,against the core (ex-food and fuel) inflation rate (Figure 5).

Figure 5: Phillips curves in Japan, 1985-2016


In common with other advanced economies, the Phillips Curve showed a markeddownward shift in the 2000s versus the previous decades. Whereas from1985-1999 the Phillips Curve implied a full-employment rate of inflation of 1.3%,during 2000-2012 the equilibrium inflation rate seems to have been negative,which is not surprising given the prolonged period of deflation in Japan. Since2013, though, it appears that the curve might have shifted upwards although wecaution that eleven data points is still too few to draw firm conclusions. But even ifit has, it's still nowhere near signaling that a 2% inflation rate can be achieved in a'stable manner'. Indeed, on current estimates, GDP would have to be maintainedat about 4% above the full employment level to achieve 2% underlying inflation.

So, while we think there's reason to believe that deflation has been beaten, wethink it is premature to argue that 2% inflation is today a reasonable expectation.But just as in the US, we think a more positive case can be made. With anunemployment rate of only 3% – the lowest in more than 20 years –Japanis arguably close to full employment. The Tankan survey shows that firmsconsider labour market conditions to be the tightest since the bubble years ofthe mid-1980s. As in the US, wage growth is lacking to provide a convincingargument that higher inflation is imminent. Or is wage growth just lagging?

Inflation expectations are falling againIf only people believed them, it seems the BoJ thinks, they'd already haveachieved 2% inflation. Expectations play a significant role in how central banksthink about policy transmission and communication. If firms anticipate higherinflation, then the real cost of borrowing today will be lower than it may currentlyseem. So the BoJ's explanation of how QQE and negative interest rates are

15 September 2016



supposed to stimulate growth and inflation relies importantly on a rise in inflationexpectations due to their stronger and more credible commitment to their inflationtarget coupled with the decline in nominal interest rates as they increase assetpurchases and, more recently, negative short-term rates.

So evaluation of the success of their policy requires an understanding ofhow inflation expectations have responded. We examine four measures ofexpectations. First, from the perspective of firms, the Tankan survey asks whetheroutput prices are expected to rise, fall or stay the same and the BoJ reports adiffusion index which is the difference between expectations of higher and lowerprices (Figure 6). The series shows a gradual lessening of deflation expectationssince 2010 suddenly improving markedly – by 10ppts – immediately after theintroduction of QQE in 2013Q2. By 2014, a slight bias in favour of expectingrising prices was reported, but it appears (a new survey since 2015) that thoseexpectations reversed quickly and this year again more firms expect output pricesto fall than to rise.

Figure 6: Tankan survey: diffusionindex of firms' expected outputprices


Figure 7: ESRI consumer confidencesurvey: year-ahead inflationexpectations


The Cabinet Office asks consumers for their views on inflation one year aheadand it shows a sharp rise in the proportion of respondents expecting 2% or higherinflation in 2013, but over the past year that encouraging trend has completelyreversed (Figure 7). Fewer people expect deflation than was the case prior toQQE being announced, but by this measure inflation expectations have broadlyweakened over the past year.4

The third measure of inflation expectations we follow is another survey, butof institutional investors rather than households (Figure 8). Market participantsshow a very similar pattern of inflation expectations as consumers and firms:sharply higher expected inflation immediately after the announcement of QQEbut diminishing expectations – and essentially a reversion to the pre-QQE level– since early 2015.

4 The Bank of Japan has conducted a quarterly survey of households medium term inflation expectationssince 2006. But and even adjusting for evident bias – even during years of deflation households reportedlyexpected inflation one or five years ahead of about 4% – that survey has shown no upward or downwardtrends in recent years.

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Figure 8: Quick survey of investorexpectations for inflation 3yrs - 10yrsahead

Sources: Quick and Deutsche Bank Research

Figure 9: 5yr ahead implied inflationfrom inflation swaps

Sources: Bloomberg Finance LP and Deutsche Bank Research

A pure market-based measure of implied 5yr ahead inflation is available fromthe inflation swaps market (Figure 9). Market pricing of future inflation was moreresilient than investors' expectations, holding up well into the middle of 2015 –but again at nowhere near 2% – but collapsing at the beginning of this year backto near zero.

Real interest rates are rising even while nominal rates fallFor a given nominal interest rate, falling inflation expectations mean a lower exante real interest rate. In the first figure below, we plot the difference betweenthe nominal 10yr JGB yield and two measures of inflation expectations: the Quicksurvey of investors' one-year ahead inflation expectations and the inflation swapsimplied rate of inflation in five years (Figure 10). Using the Quick survey measureof inflation expectations, ex ante real yields had fallen about 0.5% between2013Q1 and 2014Q4 (the dates of the BoJ's initial assessment). Real yields thenrose in the second half of 2015, fell sharply in the wake of negative interest ratesand are today about where they were at the end of 2014. Implied inflation frominflation swaps paint an even more discouraging picture: after falling by 0.5%during 2013-14, real yields have risen 30bps since 2014Q4. A more charitablecomparison would focus on the 1.1% decline in real yields from late 2012 tothe end of 2014, but the rising trend to real yields since mid-2015 is a worryingdevelopment.5

5 If we construct a measure of average expected inflation from the household survey summarized in Figure7, we find that expected inflation has fallen even more than that implied by the Quick survey or inflationswaps, implying an even larger possible rise in ex ante real rates.

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Figure 10: Real JGB yields measuredusing investor expectations (Quick)or market pricing (Infl swaps)

Sources: Bloomberg Finance LP, Haver and Deutsche BankResearch

Figure 11: Actual vs expectedinflation


The BoJ has noted the difficulty in sustaining higher inflation expectations, oftendescribing expectations as perhaps excessively adaptive or backward-looking.But the truth is perhaps a little more complex. Whether it's investor expectationsas in the second figure above, or household expectations or market pricing offuture inflation, which have behaved very similarly, the recent experience hasbeen that inflation expectations rose sharply on the announcement of QQE orindeed even after the election in September 2012, months before actual inflationrose (Figure 11). And initially, as actual inflation fell in the second half of 2014inflation expectations held up reasonably well. But when inflation fell back to zero,it seems, investors and households lost hope and inflation expectations declinedback to pre-QQE levels.

The announcement of negative interest rates not only didn't revive inflationexpectations, by all of our measures inflation expectations fell after the rate cutin January. Are negative rates a step too far?

Are negative rates counterproductive?If the announcement of negative interest rates was met by a decline in inflationexpectations rather than an increase, did this negatively impact consumerspending and business investment too? With only half a year's data, it's hard tobe conclusive on this point, but we think at the very least negative rates have notprovided any stimulus, and the rising ex ante real interest rates do seem to haveboosted household savings.

Official data on household income are only available up to the first quarter of2015, so we cannot look to household savings rates for evidence. We can see thatconsumption by Japanese households has fallen relative to employment incomeor, as we show in Figure 12, relative to gross domestic product.

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Figure 12: Household consumption


Figure 13: Annual change in monthlysavings rate

Sources: CEIC and Deutsche Bank Research

In Figure 13, we show the difference relative to the same month a year earlier inthe savings rate calculated from the monthly survey of income and expenditureby wage-earning households. It is not a complete picture of household incomeand expenditure across the country but it is informative, we think. In 2013, asthe QQE program was introduced and inflation expectations rose, savings rateswere lower than they had been a year earlier. This is the anticipated effect ofquantitative easing. Then there was the pre-tax hike decline in savings – followeda year later by a spike in the savings rate by comparison. But since mid-2015 – aperiod during which inflation expectations have been falling faster than interestrates – savings rates have remained higher than they were a year ago, even afterthe implementation of negative rates in January.

This may not be conclusive that negative rates have adversely impactedhousehold confidence and had a 'perverse' impact on savings behavior –consumer confidence surveys have not shown a sudden plunge in confidence –but we think negative rates at least did not turn around an increasingly cautioushousehold sector. And to the extent that the decline in inflation expectations wasa consequence of the negative rate policy – and we have not demonstrated thatcausal link – negative rates may have been counter-productive.

Financial stability implications of QQE and negative ratesThe BoJ's pursuit of higher inflation via unconventional policies has not metwith universal support. While few would argue with the goal, it seems manyparties in Japan are unhappy with the methods. By driving bond yields – bothreal and now nominal – below zero, the policy has earned the ire of institutionalinvestors like pension funds and insurance companies and ultimately retireeswho rely on fixed incomes. Market participants have complained that the bondmarket is becoming increasingly illiquid and banks have complained that negativeinterest rates shrink already narrow net interest margins, harming the creditintermediation function. The BoJ seems committed to seriously examining theseissues in their forthcoming assessment report; here we offer a few observations.

We start with the impact of negative rates on banks. Banks have made knowntheir opposition to negative rates – indeed, to the decline in longer term yieldsas well. Unable, or unwilling, to cut deposit rates much given they were alreadynear zero, the decline in lending rates resulting from QQE has been costly.Perhaps the most buoyant part of banks' loan portfolio is the mortgage book,where benchmark rates on housing loans have fallen 80bps since January whiledeposit rates have fallen perhaps one or two basis points. The FSA estimatesthat bank profits would be lower by JPY300bn because of the shift to negativerates. The value of bank stocks, which had initially risen with in anticipation of

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a more aggressive reflation policy in late 2012 plunged with the announcementof negative rates (Figure 14).

Figure 14: Topix bank equity index vsbroad market

Sources: Bloomberg Finance LP and Deutsche Bank Research. Thevertical bars show the key dates of QQE: inception in April 2013,expansion in October 2014 and negative rates in January 2016.

Figure 15: Domestic bank loans


Credit growth, measured by bank loans, slowed in the second half of 2015 andis slightly slower since January's rate cut (Figure 15). Seasonally adjusted, loangrowth in Q1 was slowest in three years in Q1 at 0.3%QoQ although it recoveredin Q2 to its previous trend (Figure 16). Banks report that while housing loans haveresponded to the decline in benchmark rates since January, business demandfor credit has weakened. As we saw with behavior of inflation expectations,the introduction of negative rates appears to have damaged business sentimentrather than boosted it.

Figure 16: Domestic bank loans,seasonally adjusted


Figure 17: Bank loans and advancesby sector


Observe also that while bank credit to corporations is growing more slowlyin recent quarters (Figure 17), this is not offset by higher bond issuance.It may be that firms are issuing more longer term debt, but the stock ofcorporate bonds outstanding continues to decline (Figure 18). Banks are not beingdisintermediated in a negative rate environment, firms are not investing.

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Figure 18: Domestic corporate bondsoutstanding


Figure 19: BoJ's Bond Market Survey

Sources: Bank of Japan and Deutsche Bank Research

Lastly, the Bank of Japan hears first-hand from participants in the governmentbond market how liquidity has deteriorated. They have tracked this since earlylast year in a quarterly survey excerpted in Figure 19. Overall, by the time of lastmonth's survey none of the respondents said the bond market was performing ata high level. As many as 46% of respondents described the market as functioningat a 'low' level, up from 15% a year earlier. Fewer than a quarter of participantsreport that they are able to deal at their expected size or prices, half the figuresreported a year ago. As the BoJ now holds nearly 40% of the market, inevitablyliquidity will suffer.

How does QQE and negative rates impact bond yields?

If the Monetary Policy Board is indeed considering adjusting its asset purchasesor the negative interest rate strategy, they will want to understand how theseaspects of policy have affected bond yields. Here, we apply a model of bond yieldssimilar to that applied successfully by our colleagues in the US. 6 We model the10yr JGB yield as a function of macroeconomic variables – inflation and growthexpectations – and financial variables – short-term interest rates, internationalinvestor purchases of JPY bonds, JGB yield volatility, and the stock and flow of theBoJ's JGB holdings and the growth in the combined assets of the Fed and ECB.7

6 Hooper, Peter, Matthew Luzzetti and Torsten Slok, "Low long rates could induce faster Fed rate hikes," inGlobal Economic Perspectives, Nov 12, 2015.

7 To be precise, we use the following variables: the month-end call rate; 30-day average standard deviationof the 10 year JGB yield; the Quick measure of inflation expectations; the Sentix survey of institutionalinvestors' GDP growth expectations over the following year; BoP flows of foreign investor purchases ofJapanese fixed income securities as a % of GDP; growth in combined Fed and ECB assets in yen terms;purchases of JGBs by the BoJ as a % of GDP and the stock of BoJ holdings of JGBs as a % of GDP.Following our colleagues' example, we constrain the coefficients on the call rate and inflation expectationsto sum to one.

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Figure 20: Results of JGB yield model

Source: Deutsche Bank Research

Compared with the results of the model applied to the US Treasury yield, themost notable differences are, first, that foreign central bank asset growth isunimportant to the JGB yield while it was a significant driver of lower US yields,and secondly that the flow effect on JGBs is significantly larger relative to thestock effect. A 1% of GDP increase in the flow of JGB purchases by the BoJ lowersbond yields by 17bps while a 1% of GDP increase in the stock of JGB holdingsonly depresses yields by 1bp.

Graphically, we plot in Figure 21 the time series of the stock and flow effects.Recall that the BoJ was already acquiring bonds before April 2013 but the QQEannouncement has a major impact on bond yields through the increased flowof purchases. But as the size of the flows declined relative to GDP this effectweakened until in October 2015 when the size of the QQE program was increasedand the flow effect grew again. As of June 2016, the flow of purchases wasdampening JGB yields by an estimated 74bps while the stock effect was worth56bps.

Figure 21: The stock and flow effectson JGB yields


Figure 22: Stock plus flow versus allother factors determining JGB yields


Put another way, the combined impact of JGB purchases – the flow plus stockeffects – was dampening bond yields by about 1.3% versus -25bps in March 2013.All other factors determining bond yields summed to 1.1% versus 1.2% in March2013 (Figure 22). Virtually all of the reduction in bond yields since March 2013has been due to asset purchases.

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How could these results inform the Monetary Policy Board's decision? A JPY10tnreduction in JGB purchases, to take the lower end of the potential range ofpurchases we think they might target, implies about a 0.34% decline in bondyields, all other things equal, according to our model. To try to offset that via a cutin short term interest rates would require an implausibly large 60bps rate cut. BoJofficials have noted that bond yields were surprisingly responsive to the rate cutin January. Our model suggests that's because inflation expectations fell whenthe rate cut was implemented and it was those lower expectations that did mostof the work driving yields lower. All things equal, a 10bps decline in the call ratewould be expected to lower JGB yields by only about 6bps.

Conclusion: our assessment of QQE and negative rates andwhat we expect next week

We think the evidence presented above demonstrates indeed that quantitativeeasing has had a very significant impact on nominal yields in Japan, driving themdown by 1.3% relative to what they might otherwise have been. Conversely, wethink that when the effect of falling inflation expectations is removed, the impactof the introduction of negative interest rates on bond yield was very modest. Thecall rate fell by about 13bps eventually, imparting a negative bias to bond yieldsof only about 7bps.

The problem is that inflation expectations have gone down over the past twoyears, despite the BoJ twice augmenting its policy – raising the pace of assetpurchases in late 2014 and cutting rates below zero this year. Indeed, the evidencesuggests that negative rates have been counter-productive, dampening inflationexpectations and thereby raising real rates rather than lowering them.

The BoJ may conclude that the benefits of negative interest rates outweigh thefinancial stability costs. We disagree because we see very little benefit at all fromnegative rates and both financial and possibly macroeconomic costs. We do notexpect the BoJ staff's assessment to agree with us on this point.

We expect, therefore, that the staff's assessment and the Monetary Policy Board'sconclusion, will be that both QQE and negative interest rates play an importantrole in moving Japan towards 2% inflation. While we think the evidence doesnot yet show that 2% is a realistic target, we expect the Board to reaffirm thattarget although perhaps in October they will again postpone the date they expectto achieve it.

Much commentary has speculated on the dimensions in which the Board couldadjust policy next week. Our base case is, in fact, that they will do nothing. Ifbackward-looking inflation expectations are the main reason, in their view, fornot achieving 2% inflation then a continuation of current policies would be areasonable decision: eventually expectations will change as measured inflationrises.

But while we think the Board collectively does not agree with the IMF and otherobservers that they are rapidly approaching a limit to their asset purchasingprogram (especially the JGB part of it), we think the Bank will try to be responsiveto market concerns about illiquidity in the bond market and the damage to banks'profitability and investors' returns. One way this concern could find expressionwould be to make the JGB purchase program more flexible, returning to a range

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– JPY70tn to JPY90tn, for example rather than a hard JPY80tn target – with lessemphasis on buying long-term bonds.

It will be difficult to avoid this being interpreted as a tapering off of the assetpurchase program. So, to compensate – to try to limit the rise in JGB yields – suchan announcement may be combined with another interest rate cut. As discussedabove, we think the Bank may exaggerate the sensitivity of bond yields to short-term rates, in which case the net effect of this could be significantly higher yields,which would be damaging to the monetary program.

A steeper yield curve therefore seems to us to be a very likely outcome from sucha policy package.

If they do cut the interest rate on the Policy Rate Balance from -0.1% to -0.2%,we think the Board may choose not to lower the interest rate on Basic Balance orthe Macro Add-on Balance. Otherwise, the rate cut will do much more damage tobank profitability. Indeed, to alleviate the pressure on the banks, the Board mightmerge the Macro Add-on into the Basic Balance, providing a bit of interest raterelief.

As this discussion shows, the next change in policy could prove to beexceptionally difficult to communicate – changes in asset purchase amounts andin one or more interest rates. It will not be possible to forge a consensus – we arereasonably sure at least two Board members would vote against at least someaspects of such a package – but it may be too difficult even to try to implement.

Michael Spencer (+852) 22038303

15 September 2016



Central Bank WatchG3

US

Figure 23: G3 policy rates



With the market odds on a Fed rate hike having dropped to near 20% and theFed having done little or nothing to discourage that movement, the chances ofa rate hike this month now look very slim. A reasonable case could be made fora move now based on the data in hand, and we expect that case to strengthenfurther in the next couple months, with the Fed raising rates in December and acouple more times in 2017.

JapanWe expect next week’s assessment of QQE with negative rates will conclude thatthe policy would have worked had it not been for exogenous shocks – falling oilprices and weaker Chinese growth – a stronger negative impact of the 2014 taxincrease and backward-looking inflation expectations. Such a conclusion wouldsupport an unchanged policy stance. Either at this meeting or in October whenthe Bank updates its economic projections, they may choose to adjust policy togive themselves more flexibility on asset purchases – setting a range rather thana fixed JPY80tn target and perhaps reducing purchases of very long-term bonds –but offset that with a further cut in the interest rate target. The latter’s impact onbank profitability could be softened by applying the rate cut only to the policy ratebalance or folding the macro add-on balance into the basic balance at a positiveinterest rate.

EurolandAs expected, the ECB kept policy steady in September, with Draghi expressingconfidence in the transmission mechanism but remaining cautious on theoutlook. We view further deposit rate cuts as unlikely but expect a 9-12 monthQE extension in December, accompanied by moves to ensure sufficient eligibleassets, most likely through an increase in the issue limit.

Other European countries

UK

Figure 24: Key European policy rates



The BoE eased monetary policy more aggressively and more rapidly than expectin August. The signal is that the 0.25% bank rate will fall again but to a floor justabove zero by year end. Our view now is this happens in November.

SwedenIn February, the Riksbank cut the repo rate 15bp to -0.50%. The Central Bank’srate profile suggests there is a small risk of a further cut.

SwitzerlandThe SNB left policy on hold at its last meeting with rates well below zero. We seefurther gradual depreciation of CHF vs. EUR going forward.

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Dollar bloc

Canada

Figure 25: Dollar Bloc policy rates



We continue to expect that the Bank will remain on hold through the end ofthis year. With respect to the medium-term outlook, structural adjustment ofthe Canadian economy toward non-resource sectors may be hampered by anuncertain global growth picture as well as elevated inventory levels in bothCanada and the US. The upshot is that monetary policy should remain highlyaccommodative until well into the second half of 2017, if not longer.

AustraliaWe think that the May and August moves will likely mark the end of the RBA’sactions for this year, with the ‘okay’ tone to the activity data and the broadly asexpected June quarter CPI giving the Bank some time to assess the outlook. Thatsaid, we retain the view which we have held since the May RBA Board meetingthat the Bank will end up taking the cash rate lower still as we expect inflationto eventually undershoot the RBA’s current published forecasts. Specifically welook for a 1.25% cash rate come mid-2017.

New ZealandWe think the RBNZ will have no choice but to ease more than is priced now inorder to bring the interest rate differential with the rest of the world down andhence take pressure off the exchange rate. Unless, the rest of the world raisesinterest rates by more than we expect. At this stage we think the former is morelikely. We see the RBNZ easing again before the year end and then again in H12017. RBNZ’s higher track for the exchange rate reduces the prospect of anotherrate cut this year somewhat.

BRICs

China

Figure 26: BRIC policy rates



August activity data stabilized. The property boom continued. It puts upside riskto our H2 GDP forecast and downside risks to our 2017 forecast. We expect policyactions to happen in H1 2017 instead of H2 2016, including two RRR cuts andone interest rate cut.

IndiaCompared to our earlier view that the RBI will maintain a prolonged pause in theperiod ahead, we now expect the bank under the new Governor to cut the reporate by at least 50bps in this cycle. Currently markets are pricing in expectationsof a little more than 25bps cut; we think the RBI will readily deliver that and somemore in the months ahead.

BrazilAs the recession has allowed inflation to decelerate, the impeachment ofPresident Dilma Rousseff has reduced political risk, and the BRL has recoveredsome ground, we believe the next BCB move will be a reduction in interest rates,beginning with a 25bp cut in October (although a delay in passing some key fiscalmeasures in Congress might prompt the BCB to wait until November).

RussiaWe expect inflation to fall to 5.7% by end-2016 and 4.5% by end-2017, pavingthe way for the CBR to bring the policy rate to 7.5 within a corridor system

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that is +/-100bps by end-2017. We expect 50bps on each of the September andDecember meetings that are followed by the Q&A sessions.

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Figure 27: Central Bank policy rate monitor


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Figure 28: Key Economic Forecasts

Source: See below

Figure 29: Forecasts: G7 quarterly GDP growth

Source: National authorities, Deutsche Bank Research

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Appendix 1

Important Disclosures

Additional information available upon request

*Prices are current as of the end of the previous trading session unless otherwise indicated and are sourced fromlocal exchanges via Reuters, Bloomberg, and other vendors. Other information is sourced from Deutsche Bank, subjectcompanies, and other sources. For disclosures pertaining to recommendations or estimates made on securities other thanthe primary subject of this research, please see the most recently published company report or visit our global disclosurelook-up page on our website at http://gm.db.com/ger/disclosure/DisclosureDirectory.eqsr

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The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition,the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendationor view in this report. Michael Spencer, Peter Hooper, Torsten Slok, Matthew Luzzetti

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?

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