Source:
https://scmp.com/comment/opinion/article/3204933/why-japan-cant-afford-abandon-its-ultra-loose-monetary-policy
Comment/ Opinion

Why Japan can’t afford to abandon its ultra-loose monetary policy

  • The Bank of Japan’s decision to raise its bond yield cap has shocked markets, with many seeing the move as the start of policy normalisation
  • In reality, the central bank has good reason to keep policy loose, but it will need to convince markets of that before they trigger a dangerous bond sell-off
Haruhiko Kuroda, governor of the Bank of Japan, speaks during a meeting in Tokyo on Monday. Photo: Bloomberg

Just when investors thought 2022 could not possibly throw them any more curveballs, the Bank of Japan (BOJ) sprang a surprise. On December 20, it relaxed its “yield curve control” policy by lifting its cap on Japan’s 10-year bond yield to half a percentage point, double the previous upper limit.

In a world in which major central banks are jacking up borrowing costs by as much as three quarters of a percentage point in one go, the higher yield cap may seem like a minor adjustment in a country where interest rates have been in negative territory since 2016.

Yet, it is precisely because Japan remains an outlier in global monetary policy – and because the timing of the BOJ’s move was totally unexpected – that the tweak is all the more significant. At a time when markets are sensitive to shifts in policy and are inclined to overreact, the signal Japan’s central bank has sent is hugely consequential.

The country’s 10-year bond yield experienced its sharpest daily rise in two decades following the BOJ’s announcement and currently stands just below the new 0.5 per cent cap. Moreover, speculative bets against the yen – one of the most popular trades in markets due to Japan’s negative rates which make the yen the preferred funding currency for so-called carry trades – are starting to lose their appeal.

The BOJ insists the adjustment was designed to make its yield curve control framework more sustainable. Yet, many investors view the tweak as the beginning of the end of the era of ultra-low rates in Asia’s second largest economy. Having withstood the dramatic rise in global bond yields this year, Japan, many believe, is finally caving to pressure to begin normalising policy.

This could well be the case. Japan has looked ever more isolated as other economies raise rates aggressively. More worryingly, years of super-loose policy have grossly distorted asset prices, with the BOJ owning over half of Japan’s increasingly dysfunctional government debt market.

The headquarters of the Bank of Japan in Tokyo. Photo: Reuters
The headquarters of the Bank of Japan in Tokyo. Photo: Reuters

The plunge in the yen, moreover, has driven up inflation to its highest level since 1981, causing real wages to fall for seven straight months. This has contributed to the sharp slide in prime minister Fumio Kishida’s approval ratings.

Even if markets overreacted to last week’s move by the BOJ, the central bank is tempting fate. Bond investors have been betting against the yield curve control programme for some time. The surprise decision to loosen the yield cap risks letting the monetary tightening genie out of the bottle, encouraging investors to bet that BOJ governor Haruhiko Kuroda’s successor – who takes the reins in April – will take more forceful measures to normalise policy.

The battle between the BOJ and the markets is set to intensify. The question is whether the central bank can control the narrative amid mounting speculation that it will be forced to tighten policy.

Several factors suggest the BOJ still has the upper hand. The strongest one by far is that Japan cannot afford to raise rates significantly.

Although inflation (excluding fresh food prices) reached 3.7 per cent year-on-year last month, this is still far below levels in America and Europe. More importantly, wage growth – which has eluded Japan for decades – is needed to sustain the rise in prices. While the coming spring wage negotiations could result in a significant pay increase, many firms are fearful that consumers will balk at higher prices, making them reluctant to raise wages.

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The last thing the BOJ wants to do is tighten policy prematurely when it is still not clear whether it has succeeded in breaking Japan’s deflationary mindset once and for all. With global inflation already showing signs of having peaked and government measures to lower household electricity bills expected to slow price rises next year, the BOJ has little choice but to keep policy loose to ensure that inflationary psychology takes hold.

Furthermore, if there is one country that must tread carefully in exiting ultra-loose policy, it is Japan. Even a modest tweak to the yield curve control framework caused the country’s 10-year bond yield to surge, triggering a sell-off in other major debt markets. Japan’s position as the world’s largest creditor nation, with US$3.6 trillion of net assets held overseas, amplifies the effect of sudden moves by the BOJ.

If Japanese banks and pension funds – which are among the world’s biggest institutional investors – start selling their foreign assets aggressively and repatriate their money to capitalise on higher yields, widespread financial contagion could ensue at a perilous time for the global economy.

Far from firing the starting gun on a tightening in Japanese monetary policy, Kuroda is relieving some of the pressure on his successor by trying to minimise market ructions. The BOJ is finding it difficult to maintain credibility. But this pales in comparison with the problems a disorderly exit from ultra-loose policy would cause for Japan and the markets.

The era of cheap money in Asia’s second largest economy is not over yet.

Nicholas Spiro is a partner at Lauressa Advisory