The International Monetary Fund on Thursday called for "more flexibility" in Japanese long-term yields after the Bank of Japan jolted financial markets with its surprise decision to widen the trading band last month for 10-year government bonds.
Accommodative monetary policy is still appropriate, and "exceptionally high uncertainty" remains over the inflation outlook, IMF staff said. Still, upside risks to inflation are prominent, partly because of the delayed impact of a weaker yen, second-round waves of imported inflation and border reopening, they added.
"The policy challenge in the near term is to ensure that the (BOJ's) 2 percent inflation target is reached durably, without overshooting significantly, while preserving financial stability," the IMF staff said in a statement capping their visit to Japan for bilateral consultations with Japanese authorities.
To ensure more flexibility, the IMF staff proposed the BOJ consider further widening the 10-year trading band, raising the 10-year bond target, or targeting shorter bonds under its yield curve control program.
Another option is for the Japanese central bank to shift its focus to a "quantity target" of government bond purchases, rather than targeting yields.
Japan's core consumer inflation hit 4 percent last month, double the pace envisaged by the BOJ. Most of the rise is due to higher import costs, magnified by the yen's weakness, a major reason why the BOJ remains committed to monetary easing.
"Japan's inflation could be at an inflection point," Gita Gopinath, first deputy managing director at the IMF, said at a press conference.
At this point, Japan is unique because it faces both significant upside and downside risks to inflation, an environment that calls for "very carefully thought-out policy steps," Gopinath said.
"Given the two-sided nature of the risks to inflation, we see that having more flexibility on long-term yields can help at the appropriate time," she added.
In December, the BOJ decided to allow 10-year yields to trade in a range of minus 0.5 percent and 0.5 percent, wider than the previous band of minus 0.25 percent and 0.25 percent, a step the bank said was aimed at fixing market distortions. But markets took it as an effective rate hike.
The abrupt move sent long-term bond yields sharply higher, feeding expectations of a shift toward tighter monetary policy despite the BOJ's insistence that its inflation target is still far off and ultralow rates will continue.
The BOJ says it will maintain its ultraloose policy until inflation reaches its 2 percent target in a stable manner.
"Providing clear guidance on the preconditions for a gradual policy rate change in the future would help anchor market expectations and strengthen the credibility of the BOJ's commitment to achieving its inflation target," the IMF staff said.
"Well communicated changes to monetary policy settings will facilitate smoother transitions and protect financial stability."
The BOJ's dovish streak pushed the yen sharply lower to levels unseen in three decades relative to the U.S. dollar last year, prompting Japanese authorities to intervene in the foreign exchange market to arrest the rapid depreciation.
Such interventions should be limited to "special circumstances" such as when disorderly market conditions prevail and when there are risks to financial stability, the statement said.
IMF staff regularly visit member countries to discuss their economic and financial situations with local government officials. Based on such bilateral discussions, the organization releases a report.
The IMF also underscored the need for heavily-indebted Japan to promote fiscal reconstruction. Japan has ramped up spending in response to the COVID-19 pandemic and rising prices caused by Russia's war in Ukraine and higher import costs.
The latest Cabinet Office projections show Japan will see its primary deficit triple from its earlier forecast to 1.5 trillion yen ($11 billion) in fiscal 2025, the target year for achieving a surplus, due to a substantial increase in defense spending.
"Amid the ongoing recovery, rising inflation, tighter labor markets, and a closing output gap, fiscal policy support should be withdrawn more quickly," the IMF said.
It called for Japan to provide more realistic growth and fiscal balance forecasts, saying those provided by the government have "historically been too optimistic."
