Japan’s central bank is at a policy crossroads: which path will new chief Kazuo Ueda take?

With inflation rising, the Bank of Japan faces a dilemma: either cave to pressure and raise bond yields, incurring losses on its holdings and losing its long war on deflation; or continue to suppress yields and risk an even bigger fallout
The decision falls to new governor Ueda, and no one knows what he will do yet

Nicholas Spiro

Published: 10:00pm, 16 Feb 2023

Why you can trust SCMP

When the economic disruptions from the Covid-19 pandemic began to bite, causing inflation to soar and ushering in a regime change in markets that created huge uncertainty about interest rates and valuations, Japan was a beacon of predictability.

As other leading central banks raised borrowing costs aggressively, the Bank of Japan (BOJ) remained steadfastly committed to its ultra-loose monetary policy. Determined to banish the chronic deflation that had plagued Japan for decades, the BOJ resisted the dramatic rise in bond yields in other countries by fiercely defending its cap on the country’s 10-year yield and keeping rates in negative territory.

Yet, as Japan’s inflation rate rose sharply last year, the underpinnings of this predictable policy regime began to crumble.

In December, speculative bets against the BOJ’s “yield curve control” measures forced the central bank to lift the cap to half a percentage point, letting the monetary tightening genie out of the bottle and reinforcing the perception that Japan was caving to pressure to start normalising policy.

On top of the uncertainty surrounding Japan’s exit from super-loose policy, an untested and little-known academic has just been nominated to take the reins of the BOJ. On Tuesday, prime minister Fumio Kishida appointed Kazuo Ueda to replace Haruhiko Kuroda as governor in April.

Provided Japan’s parliament approves his nomination, Ueda will take on the toughest job in central banking right now: deciding when and how to shift to tighter policy following a decade of unprecedented easing.

Outgoing Bank of Japan governor Haruhiko Kuroda (left) and the Japanese government’s new nominee, economics professor Kazuo Ueda, seen at the G7 Finance Ministers’ Meeting in Sendai, Japan, in May 2016. Photo: EPA-EFE

To say that the stakes are high for the BOJ, Japan’s economy and global markets would be a gross understatement. Ueda is an unknown quantity, partly because he is the first nominee to head the BOJ who was not drawn from the central bank or the finance ministry. Furthermore, nobody knows whether he is a hawk or a dove.

More worryingly, the risk of a policy mistake is significant given the scale of the BOJ’s impact on domestic and international markets. Not only does the central bank own more than half the country’s government bonds, it has added to global liquidity over the past several years, preventing bond yields from rising more sharply than they already have.

As if that were not enough, while Japan’s so-called “core-core” inflation rate, which excludes energy and fresh food, hit 3 per cent in December – relatively low by global standards but a 32-year high in Japan – a premature increase in rates could endanger the progress made in breaking an entrenched deflationary mindset.

In a report published on February 11, CLSA noted that the job of BOJ governor was a poisoned chalice. “As the BOJ edges toward [policy] normalisation, being made skipper is what rugby players call a ‘hospital pass’”, the report said.

Still, an Ueda-led BOJ could be just what Japan needs right now. As an outsider, Ueda would have a freer hand in devising a strategy to exit the discredited yield curve control framework – or at least make it a lot more sustainable – and normalise policy in a prudent and credible manner.

01:37

Taxi operators facing bankruptcy in Japan hit 10-year high, according to survey

While there is an intense debate over the degree to which Japan needs to tighten policy – the BOJ expects inflation to cool later this year, driven partly by government subsidies to lower energy costs – and strong wage growth is required to embed expectations of higher prices, the current policy stance is extreme.

If bond yields rise further, the BOJ will incur more losses on its massive holdings of Japanese government debt, which have risen to a staggering 105 per cent of the country’s GDP, data from CLSA shows. Yet, if the central bank keeps suppressing yields, it will take on more risk and suffer heavier losses if bond prices keep falling.

The consequences for global markets are huge. Speculation about a further increase in yields caused Japanese pension funds and life insurers – which are among the world’s biggest debt investors – to sell US$180 billion of long-term foreign bonds last year, the fastest pace of divestment in recent history, data from JPMorgan shows.

Japanese outflows from global bond markets – particularly Australia and Europe where Japanese investors’ holdings are the largest as a share of the market – could accelerate if yields on domestic debt become more attractive.

Commuters outside Tokyo station in the centre of the Japanese capital. Photo: AFP

The timing could not be worse. Global debt markets are under renewed strain because of increasing signs that the Federal Reserve will have to raise rates more sharply than expected because of America’s persistently strong labour market.

This heaps more pressure on Ueda to get the exit strategy right. The lack of clarity about his views, coupled with the huge domestic and external risks in normalising Japanese monetary policy, have turned the BOJ into one of the most important wild cards for markets.

Careful communication with investors will be crucial. Japan has never been this close to banishing deflation once and for all. It has also never had to deal with such acute distortions in asset prices stemming from years of ultra-cheap money. Ueda has to find a way of squaring the circle without triggering a crisis. This is easier said than done.

Nicholas Spiro is a partner at Lauressa Advisory

Post