While many major developed economies have experienced sharp rises in interest rates and bond yields over the last year or so, there has been one notable exception: Japan. As the country has strived to break free from the deflationary quagmire that has periodically dogged it since the 1990s, monetary policy has been kept extremely loose. However, with underlying inflation at multi-decade highs, pressures are growing for a policy change, which could potentially have ramifications beyond Japan’s shores.
The BoJ’s long battle against deflation
Since the collapse of Japan’s asset price bubble in the early 1990s, the country has been dogged by excessively low inflation and periods of outright deflation (i.e. a fall in the general price level) that successive policy initiatives have failed to banish. The Bank of Japan (BoJ) has slashed interest rates and pursued various bouts of Quantitative Easing (QE or buying bonds) over the years in a bid to shift inflation to a sustainably higher trajectory, but deflationary pressures have proven difficult to shake off.
The ultra-loose monetary policy framework instigated seven years ago remains in place today, albeit with some relatively minor tweaks along the way. In January 2016, under the stewardship of Governor Haruhiko Kuroda, the Bank of Japan introduced a Negative Interest Rate Policy (NIRP), cutting its key short-term interest rate to -0.1% in a bid to weaken the Yen and lift prices. Later that year, in September, the monetary authorities introduced a framework it called Quantitative and Qualitative Easing with Yield Curve Control (QQE with YCC). Under this policy the BoJ would keep buying assets (mainly Japanese Government Bonds, or JGBs) until inflation rose above its 2% target on a sustainable basis, but would also set a target for the 10-year JGB yield ‘around zero percent’1.
The original aim of YCC was to stimulate activity by restraining short-and medium-term interest rates, which influence corporate borrowing rates, while at the same time not reducing long-term interest rates too much, given concerns over potential adverse effects on pension funds and life insurers. However, the policy has been criticised for distorting the functioning of the bond market, and damaging banks’ net interest margins.
In part to address such concerns, the YCC policy has been tweaked a few times in recent years. Most recently, in December 2022, with rising global bond yields putting upward pressure on JGB yields, the BoJ surprised markets by announcing that it would increase the band in which it would allow the 10-year JGB yield to trade from +/-0.25% to +/-0.5%, while also increasing bond purchases to stop yields rising above this upper limit2.
Inflation, at last
However, signs that inflation pressures are becoming more entrenched, along with a recent change in leadership at the BoJ, have raised speculation that a more significant change in policy could be on the cards. A measure of underlying inflation which strips out the prices of energy and fresh food (known as the core-core rate) rose 3.8% y/y in March – the fastest pace since 19813.
Moreover, there is tentative evidence of an inflationary mindset starting to take hold among businesses and consumers. The BoJ’s latest Tankan business survey showed 1-year inflation expectations rising to 2.8%, and 3-year inflation expectations inching up to 2.3%4. Considering that corporate inflation expectations were around 1% or lower for much of the last decade, this represents a meaningful shift.
Furthermore, a pick-up in wage growth, seen by the BoJ as a necessary condition to stably meet its 2% inflation target, is also becoming evident. Against the backdrop of a tight labour market, this year’s annual wage negotiations between large companies and the unions – known in Japan as the ‘Shunto’ – resulted in a pay rise of 3.8%, the biggest since 1993, and above the 3% pace the BoJ sees as consistent with its inflation target5. Some workers will receive substantially larger wage gains; Fast Retailing, the company that owns the fashion retailer Uniqlo, has lifted pay by a whopping 40%6, while Honda will raise wages by 5%7.
YCC days numbered?
Against this backdrop, the BoJ’s ultra-loose monetary policy is starting to look inappropriate. At its April meeting, the first under new BoJ Governor Ueda, the BoJ left its policy interest rate unchanged at -0.1% and made no changes to its YCC policy.
However, the BoJ appears to be taking the first steps towards policy normalisation. Governor Ueda acknowledged the risks of adverse side effects from continued ultra-loose monetary policy and, significantly, the statement accompanying the meeting dropped guidance for “short- and long-term policy interest rates to remain at their present or lower levels.” In addition, the statement confirmed that the BoJ would conduct a broad review of monetary policy. The policy review should take 12-18 months to finish, but Governor Ueda has indicated that a change in policy could happen before its completion.
Moreover, the April meeting saw the BoJ make a significant upward revision to its inflation forecasts. It now sees inflation during the 2024 fiscal year of 2% (in line with its inflation target and versus 1.8% previously), but expects it to fall back to 1.6% in the 2025 fiscal year8.
The forecasts suggest the BoJ feels it is making progress towards lifting inflation sustainably towards its 2% target, even though it is not completely convinced that this is the case just yet, given concerns that inflation has been mostly the result of increased import costs and higher energy prices rather than strong domestic demand.
Given upside risks to the BoJ’s inflation forecasts from rising wages and higher inflation expectations, it is reasonable to expect that the YCC policy will be tweaked or abandoned altogether in the not too distant future. On 9th May, Governor Ueda said that when the BoJ can foresee inflation sustainably and stably meeting the 2% target, it will YCC and then move towards shrinking the bank's balance sheet9.
Market implications
Precisely how a termination, or a further tweak, of the BoJ’s YCC policy impacts markets will in large part depend on the economic and financial conditions, both domestically and globally, prevailing at the time. The recent fall in long-term bond yields in the US, as investors react to turmoil in the banking sector and rising recession risks, has taken some pressure off, but an exit from YCC is likely to result in a rise in Japanese yields. Analysts at JP Morgan estimate that if the BoJ exits from YCC, fair value for 10-yr JGB yields may rise to around 1%, i.e. about 60 basis points above current levels10.
More attractive bond yields at home could prompt Japanese investors – who, in a bid to secure higher returns have accumulated large holdings of foreign assets – to repatriate funds. In turn, this could put upward pressure on the Yen and global bond yields. The IMF note that the impact on sovereign yields is likely to be biggest where Japanese investors hold a large share of the market, namely, Australia, the eurozone and the US, as well as some Asian emerging markets11. Such effects could be exacerbated if leveraged investors who have borrowed at low yields in Japan to invest in higher-yielding overseas assets also reverse these so-called ‘carry trades’.
Currency markets are notoriously difficult to predict, but foreign exchange analysts at Standard Chartered Bank reckon that the Dollar-Yen exchange rate (currently around 13612) could move to 120 later this year under a scenario where the BoJ ditches YCC completely13. This would imply a rise in the Yen of around 10%.
In turn, higher bond yields and a stronger currency are also likely to have an impact on Japanese equity markets. A stronger Yen could hurt the competitiveness of companies that are dependent on exports (for example in the autos and electronics sectors). Indeed, there has often been an inverse relationship between Japan’s main stock market, the Topix, and the Yen, with a stronger Japanese currency tending to weigh on the relative performance of the Japanese equity market in local currency terms. In contrast, an ending of YCC could improve the outlook for Japanese banks if a steeper yield curve leads to a widening of net interest margins.
All of this suggests that a shift in BoJ policy, if and when it comes, could have a significant impact on financial markets, both in Japan and globally. Indeed, the IMF has warned that clear communication from the BoJ regarding any policy change will be critical to avoid market volatility14. Navigating the exit will require great care. The BoJ has not provided much excitement for central bank watchers and investors in recent years, but times are changing.
15 May 2023
1 https://www.cnbc.com/2016/09/21/bank-of-japan-decides-to-modify-policy-framework-keeps-deposit-rate-steady-sets-long-term-rate-target.html
2 https://www.cnbc.com/2022/12/20/bank-of-japan-shocks-global-markets-with-bond-yield-shift.html
3 https://www.reuters.com/markets/asia/japans-march-core-consumer-prices-rise-31-stays-above-boj-target-2023-04-20/
4 JP Morgan – Inflation expectations move up in BoJ Tankan survey
5 https://www.reuters.com/markets/asia/japans-labour-unions-confirm-three-decade-high-wage-hikes-38-2023-03-17/
6 https://www.bbc.co.uk/news/business-64232184
7 https://www.bbc.co.uk/news/business-64740171
8 https://www.ft.com/content/d69fd756-6dac-479e-8b1a-8b706b973709
9 https://www.reuters.com/markets/asia/bojs-ueda-no-pre-set-idea-how-review-could-affect-future-policy-move-2023-05-09/
10 JP Morgan - The Last Exit: YCC exit expected in the coming months despite dovish BoJ tone.
11 https://www.imf.org/en/Publications/GFSR/Issues/2023/04/11/global-financial-stability-report-april-2023
12 https://tradingeconomics.com/japan/currency
13 https://www.cnbc.com/2023/04/13/japan-yen-could-hit-120-this-year-nomura-says.html
14 https://www.imf.org/en/Publications/GFSR/Issues/2023/04/11/global-financial-stability-report-april-2023