Macroscope | Why Japan is forced to take baby steps to normalise monetary policy

The odd one out in global monetary policy is returning to the fold. On March 19, the Bank of Japan (BOJ) took the first step in ending an unprecedented era of cheap money when it jettisoned its eight-year-long negative interest rate policy, raising borrowing costs for the first time since 2007 and scrapping several other measures that were introduced in an effort to vanquish deflation.

The BOJ also ditched its policy of capping the country’s 10-year bond yield at 1 per cent and will no longer purchase exchange traded funds and real estate investment trusts. Symbolically, the return to positive borrowing costs is a landmark event in Japan’s decades-long efforts to undo the damage wrought by the bursting of the late 1980s asset bubble.

The end of the negative rate regime – a radical, albeit controversial, policymaking tool that might have helped prevent deeper deflation but crushed financial institutions’ interest income – comes not a moment too soon. Doubts over the efficacy of the policy intensified in recent years, especially when inflation began to rise sharply because of the supply shocks triggered by the Covid-19 pandemic and Russia’s full-scale invasion of Ukraine.

The signalling effect of the BOJ’s policy shift is highly significant. Not only does it indicate the central bank is increasingly confident it can hit its 2 per cent inflation target in a sustainable manner, it underpins a dramatic rally in Japanese equities that caused the Nikkei 225 index to surpass its bubble-era peak last month.

Foreign investors, who are driving the stock market rally, are convinced Japan is back. The decision by the country’s largest companies earlier this month to award workers their biggest pay rise since 1992 was a crucial factor in the BOJ’s decision and is one of the reasons market sentiment is bullish, along with shareholder-friendly corporate governance reforms and geopolitical realignments working in Japan’s favour.

In a report published on March 19, Morgan Stanley said the BOJ was able to call time on “exceptional monetary policy accommodation” because of “a much-improved macroeconomic environment” characterised by “a virtuous cycle of rising nominal GDP growth, wages, prices and corporate profits”.