BOJ governor Haruhiko Kuroda speaks at a meeting with the Japan Business Federation in Tokyo on December 26. He said the bond yield control tweaks were not the start of an exit from monetary easing but a way to make it sustainable and run smoothly. Photo: Bloomberg
by Tai Hui
by Tai Hui

Pressure is building for Japan to give up its ultra-loose monetary policy

  • Rising inflation and a weak yen are prompting expectations of a policy shift and a bond sell-off. The Bank of Japan will have to move carefully to avoid market volatility
Last year saw some of the biggest synchronised monetary policy tightening around the world, involving both developed and emerging-market central banks. However, the Bank of Japan was an exception.
It justified maintaining a negative interest rate policy and yield curve control measures – which have pegged the 10-year Japanese government bond yield at around zero per cent since 2016 – as a way to stimulate the economy. But both economic and technical market factors are making this policy combination increasingly difficult to sustain.
The first challenge to this ultra-loose monetary policy is Japan’s rising inflation. Nationwide core inflation (that is, excluding fresh food and energy) rose 3 per cent year on year last December. While this figure is not as daunting as the numbers in the United States and Europe, it could be a sign that inflation in Japan is finally picking up, which raises the question of whether such loose monetary policy is still appropriate.
Low interest rates in Japan, in contrast to sharply higher rates elsewhere, have weakened the yen substantially. This has made imported goods, especially food and energy, much more expensive in the local currency. Higher interest rates could help stabilise the yen exchange rate and reduce imported inflation.

In its January meeting, the BOJ argued that more time was needed to confirm that the current inflation momentum will prevail. This will partly depend on the spring wage negotiations between businesses and labour unions.

It can also be argued that Japan’s economic recovery from the pandemic is far from complete and its export sector is facing growing challenges, with weaker demand from the US and Europe as their economies decelerate. This could also make the central bank more hesitant about departing from its long-held policy.

There is also a question about the long-term fiscal health of the Japanese government if bond yields rise substantially. According to the Organisation for Economic Cooperation and Development, the government’s gross debt reached 226 per cent of its gross domestic product in 2021. Higher rates could raise interest expenses for the government.

Shoppers cross a road in Tokyo on December 30. Japan’s consumer inflation rate hit a 41-year high in December, as prices for everything from burgers to fuel surged. Photo: AP

This rising inflation has prompted market expectations of a policy shift. Investors sold Japanese government bonds, leading to a drop in price and a rise in bond yields. Given the central bank’s commitment to keeping 10-year bond yields at around zero, it has to keep buying them in the market.

By the end of last September, the BOJ was holding more than 50 per cent of total outstanding government bonds – 536 trillion yen (US$4.1 trillion) out of the 1,066 trillion yen total. This would have risen further in the fourth quarter of 2022 as the central bank actively absorbed the bonds sold by investors.

The central bank owning so many government bonds is creating significant distortions in the bond market. Other financial institutions, such as banks, pensions and insurance companies, may struggle to gain sufficient access to such assets. Market liquidity also suffers. This is partly why the BOJ opted to widen its target band for 10-year yields to 0.5 percentage points above or below zero, from plus or minus 0.25 points in December.

Bank of Japan ‘playing for time’ with easing stance despite yen plunge: analysts

Clearly, both economic and technical factors are pushing the BOJ to reassess its long-held policy. This will be a big challenge for the new governor, who is expected to assume the position in April. The good news is that the front runners for the job are all experienced central bankers, which should help with policy credibility and continuity.

After all, departing from such an entrenched policy requires skilled communication with the market and businesses to avoid volatility. This may not be limited to Japan and could include the global market.

The rise in Japanese bond yields could encourage Japanese to repatriate some of their overseas investments, especially in government and corporate bonds. This could prompt a sell-off in developed markets, especially those traditionally associated with higher interest rates, such as Australia and New Zealand. Britain’s experience of bond market volatility last September is a good reminder of the potential danger of unintended consequences from a shift in policy.

Tai Hui is chief market strategist for the Asia-Pacific at JP Morgan Asset Management