Japan's Central Bank Shakes Up Monetary Policy
The Bank of Japan's decision to raise interest rates for the first time in 17 years marks a significant turning point in the country's efforts to break free from its deflationary quagmire
The Bank of Japan's decision to raise interest rates for the first time in 17 years marks a significant turning point in the country's efforts to break free from its deflationary quagmire
Japan’s economy has long been plagued by stagnation and deflationary pressures, with the Bank of Japan (BoJ) employing ultra-loose monetary policies for decades in a bid to stoke inflation and growth.
However, the central bank has now made the surprising move to raise interest rates for the first time in 17 years.
This shift in policy has significant implications for businesses and investors, both within Japan and across the broader Asian region.
For years, Japan has grappled with the spectre of deflation, a phenomenon where prices and wages decline over time. T
he BoJ has consistently pursued aggressive easing measures, including slashing interest rates to historic lows and implementing various quantitative easing (QE) programs, in an effort to stimulate the economy and lift inflation to its 2% target.
Despite these efforts, deflationary pressures have proven stubbornly persistent, with the country struggling to break free from the quagmire.
The BoJ’s introduction of a Negative Interest Rate Policy (NIRP) in 2016, where it cut its key short-term rate to -0.1%, was a particularly unconventional move aimed at weakening the yen and boosting prices.
However, the tide appears to be turning, as Japan’s economy has recently begun to show signs of stronger growth. Inflation, which had been low for years, has accelerated, driven by larger-than-usual increases in wages.
This suggests that the economy may be on a course for more sustained growth, allowing the BoJ to finally consider tightening its interest rate policy.
In a surprising and aggressive move, the BoJ voted in July 2024 to increase its short-term policy rate target to 0.25% from a range of 0% to 0.1%. This marked the first interest rate hike in the country since 2007, signalling a clear shift towards monetary policy normalization.
Several key factors have contributed to the BoJ’s decision to raise rates and begin scaling back its government bond purchases.
Inflation in Japan, as measured by the core-core rate (which excludes energy and fresh food prices), has accelerated to 3.8% year-on-year as of March 2023 – the fastest pace since 1981.
This suggests that inflationary pressures are becoming more entrenched, with businesses and consumers starting to develop an inflationary mindset.
The annual “Shunto” wage negotiations between large companies and unions have resulted in a pay rise of 3.8% this year, the biggest increase since 1993. Some major corporations, such as Fast Retailing (the owner of Uniqlo) and Honda, have announced even more substantial wage hikes of 40% and 5% respectively.
This pickup in wage growth is seen by the BoJ as a necessary condition for achieving its 2% inflation target on a sustainable basis.
The arrival of a new governor, Kazuo Ueda, at the helm of the BoJ has also played a role in the policy shift.
Ueda has acknowledged the risks of adverse side effects from continued ultra-loose monetary policy and has indicated that a change in policy could happen before the completion of a broad review of the BoJ’s policy framework, which is expected to take 12-18 months.
The BoJ’s move to raise interest rates and scale back bond purchases has significant implications for businesses and investors, both within Japan and across the broader Asian region.
The termination or further tweaking of the BoJ’s Yield Curve Control (YCC) policy is likely to result in a rise in Japanese government bond (JGB) yields.
Analysts estimate that if the BoJ exits from YCC, the fair value for 10-year JGB yields may rise to around 1% – approximately 60 basis points above current levels.
The prospect of more attractive bond yields in Japan could prompt Japanese investors, who have accumulated large holdings of foreign assets in search of higher returns, to repatriate funds.
This could put upward pressure on the yen and global bond yields, particularly in markets where Japanese investors hold a significant share, such as Australia, the eurozone, the US, and some Asian emerging markets.
Currency markets are notoriously difficult to predict, but some analysts suggest that the US dollar-yen exchange rate could move to 120 later this year under a scenario where the BoJ completely ditches its YCC policy.
This would imply a rise in the yen of around 10%, which could hurt the competitiveness of Japanese exporters in sectors like autos and electronics.
A stronger yen and higher bond yields are likely to have an impact on Japanese equity markets. The Topix index, for example, has often had an inverse relationship with the yen, with a stronger currency tending to weigh on the relative performance of Japanese stocks in local currency terms.
However, the ending of YCC could improve the outlook for Japanese banks if a steeper yield curve leads to a widening of net interest margins.
The BoJ’s shift in monetary policy, if executed poorly, has the potential to trigger significant market volatility, both within Japan and globally.
Clear communication from the central bank regarding any further policy changes will be critical to avoid disruptions.
Businesses and investors operating in Japan and across Asia will need to closely monitor developments and adjust their strategies accordingly.
This may involve reassessing currency and interest rate hedging policies, reviewing the impact on supply chains and export competitiveness, and evaluating the potential opportunities and risks for different sectors of the Japanese economy.