The end of deflation in Japan?
While during the past year and a half the world’s major central banks have exited ultra-loose monetary policies to counter the post-COVID, Ukraine-war-related spike in inflation, the Bank of Japan has chosen to maintain a negative interest rate policy, making it an anomaly among large central banks. The reason behind this is that Japanese authorities are more worried about a return to deflation rather than what they view as temporary inflation. Nevertheless, the Bank of Japan has begun to adjust its policy framework to give it more flexibility to respond to inflation should it turn out to be persistent. Some economists and political analysts are worried that monetary tightening and higher interest rates may make Japan’s massive debt unsustainable and even constrain the Bank of Japan’s willingness and ability to raise interest rates. However, the risks are manageable and high government debt is very unlikely to make the Bank of Japan hesitant to raise interest rates to fight inflation, should this become necessary.
Since the bursting of the real estate and financial bubble more than thirty years ago, Japan has experienced very low inflation verging on deflation, which forced the Bank of Japan into adopting increasingly unorthodox monetary policies, including quantitative easing, qualitative easing, yield curve control and negative interest rates, in an attempt to support economic growth and prevent the economy from sliding into deflation. Once an economy falls into deflation, domestic spending may stall on the expectation of lower prices and asset price deflation helps increase the real value of liabilities, which weighs on investment and financial stability.
The post-COVID-19 spike in inflation globally and in Japan has delivered some reprieve from deflation and a debt-deflation spiral and has forced the Bank of Japan to reconsider its policies and broader monetary policy framework, originally devised to prevent deflation. Today, the bank is faced with elevated inflation, which has forced the Bank of Japan to gradually adjust its policy framework over the past year.
Inflation spiked to more than 4% in January, which is very high by Japanese standards. In August, Japanese headline and core inflation had fallen to 3.2% and 3.1%, respectively. The Bank of Japan has a mandate to maintain inflation at 2%. On its face, this would suggest that the Bank of Japan should abandon its unorthodox, ultra-loose monetary policy to bring down inflation. However, the government forecasts inflation to decline to 2.6% in fiscal year 2023 (which began in April) and 1.9% in 2024 against the backdrop of current policies.
Current inflation dynamics raise the question whether the central bank needs to tighten monetary policy at all. The Bank of Japan is certainly to avoid repeating the mistake it made in 2006 when it raised interest rates too early and pushed the economy back into an economic slowdown and deflation. Governor Ueda has said the bank wants to see inflation reach 2% on a sustainable level. This suggests that the bank is worried about the economy sliding back into deflation once the post-COVID-19 and Ukraine-related energy price shocks abate. Tightening monetary policy today would then precipitate a slide back into deflation territory.
At the same time, however, the Bank of Japan wants to avoid triggering a financial shock and market instability in case high inflation persists and forces the bank to tighten monetary policy. In order to strengthen its credibility and commitment to fight deflation, the Bank of Japan adopted a rigid, constraining policy framework in the context of the deflationary pressures of the 2010s. In particular, it committed to capping long-term yields, effectively forcing it to buy as many government bonds as necessary to keep interest rates under the cap. If the bank were forced into removing this cap overnight to regain control of monetary policy to fight inflation, markets would likely have suffered a massive sell-off and high volatility. Many investors would have been caught off-guard.
To that end, the bank has begun to make its policy and policy framework more flexible. It has begun to tweak its so-called yield curve control policy introduced in 2016 and widened the band around the zero-percent ten-year yield target from 0.25% to 0.5% in December. In July it announced that it would treat the upper and lower bound of the new interest rate corridor as references rather than rigid limits while establishing 1% as a cap, effectively allowing for a tightening of monetary policy as yields increased. In April 2023, it also announced that it was going to review its policy framework. All of this is meant to provide the Bank of Japan greater policy flexibility and prepare investors for a possible shift in policy.
The Bank of Japan is making a gradual shift towards a more flexible monetary policy framework so as to be able to tighten policies without causing financial market turmoil in case inflation fails to decline. However, to the extent that it makes its present policy framework more flexible, the shift towards a more flexible framework introduced some policy tightening. For example, widening the range around the zero target for ten-year bond yield has pushed up yields and translated into higher interest rates. So the authorities are walking a tightrope in terms of granting themselves greater flexibility and engaging in possibly unwanted monetary tightening.
Why a large government debt burden will not constrain monetary policy
Aside from risks related to rolling back its unorthodox monetary policy – unorthodox policy measures include quantitative and qualitative tightening, yield curve control and a negative policy rate – some analysts have expressed concern about what higher interest rates may do to government debt sustainability. These concerns are overblown in economic terms, which is why the level of government debt will not constrain the Bank of Japan in terms of tightening monetary policy if this is what is required to bring inflation under control. In economists’ speak, Japan does not suffer from fiscal dominance, whereby monetary policy is constrained by a high government debt for fear that higher interest rates may trigger a debt crisis.
The combination of high government debt and ultra-low, even negative interest rates has puzzled casual observers for a long time. High, potentially unsustainable government debt is supposed to translate into higher interest rates to compensate for the higher default risk. After the recent experience in other advanced economies, which saw sharp increases in debt levels coincide with ultra-low interest rates, Japan’s experience is not as unique anymore. However, Japan is the only country today that maintains a negative policy rate. At 260% of GDP, Japan has one of the highest government debt ratios in the world. However, if measured in net terms, government debt is around 160% of GDP, which is high but far less daunting than at 260% of GDP.
More important than the level of debt is its cost. It is not the nominal interest rate, which may be influenced by monetary policy, but the real interest rate that determines its effective cost. If monetary policy translates into higher nominal interest rates, nominal debt service measured in yen will increase, but so will the nominal size of the economy. A better measure of the cost of debt is the real interest rate. From this perspective, Japanese interest rates were not all that low in real terms in the past two decades, as its economy teetered on the verge of deflation, while interest rates were more or less zero. This is also why deflation was such a concern to policymakers. Deflation increases the real debt burden and real interest rates. So even if the government paid zero interest rates on its debt, real interest rates were not necessarily negative, which contributes to adverse debt dynamics.
The level of real interest rates affect debt dynamics, but they are not its sole determinant. Real economic growth and the primary fiscal balance (government revenue minus government expenditure, before interest) co-determine whether or not debt is sustainable, meaning whether the debt-to-GDP ratio increases, remains stable or declines in the long term. This is another way of saying that higher real interest rates do not necessarily undermine debt sustainability as long as real economic growth picks up, too. There is little reason to expect that real interest rates should significantly exceed the real growth rate of the Japanese economy. If economic growth falls, so should interest rates, and vice versa. This is why an increase in nominal interest rates in the context of higher inflation or higher economic growth will not fundamentally alter government debt dynamics.
There is one caveat, however. If the Bank of Japan were to proceed with significant quantitative tightening, meaning the sale of government bonds held by the bank, in the context of a need to increase long-term interest rates to keep a lid on inflation, the amount of interest-bearing debt held by the public would increase. At present, the Bank of Japan holds around 50% of all Japanese government bonds and bills, worth a little more than 100% of GDP. In a hypothetical scenario where the Bank of Japan reduces its balance sheet to the levels a decade ago, this would increase the amount of interest-bearing bonded debt to around 170-180% of GDP, up from 100% of GDP today. This could double the public sector’s debt service, all other things equal. However, such a massive balance sheet reduction would only happen in case inflation is persistently high, which in turn would help alleviate the debt burden.
This is a long-winded way of saying that the broader outlook for debt sustainability hinges not only on nominal interest rates, but also on the combination of real interest rates, real economic growth and the government’s fiscal policy. Last but not least, the average maturity of the Japanese government bond(?) is about six years, meaning it would take time for higher real interest payments to affect long-term debt dynamics, which would give the government time to adjust its fiscal policy. For the moment, however, the Bank of Japan is unlikely to feel constrained in its monetary policy actions by the high government debt levels.
A large net international creditor position provides an additional financial buffer
Moreover, Japan may have the highest government debt ratio in the world, but Japan is also the world’s largest international creditor in dollar terms, and a substantial net international creditor measured as a share of GDP. Unlike the United States, Japan does not rely on foreigners to finance its government deficit to a significant degree. Around 15% of Japanese government bonds are owned by foreigners.
In fact, an increase in Japanese interest rates would provide Japanese investors incentives to repatriate their foreign assets, and it would provide incentives to foreigners to acquire Japanese government debt. Assuming that foreign investors are more fickle, Japanese investors have every reason to buy Japanese debt once interest rates increase. Effectively, overseas Japanese assets can be seen as providing an additional financial buffer. Moreover, and perhaps more importantly, Japanese government debt is denominated in Japanese yen. This further sharply curtails roll-over risk, as the central bank can always step in to absorb newly issued debt.
Japan continues to run sizable current account surpluses, fluctuating between 2% and 4% of GDP. Surpluses mean that Japan accumulates foreign assets and, all other things equal, its net creditor position strengthens and makes more foreign assets available for potential repatriation and the purchase of government debt. It is virtually impossible for a country with a large net foreign creditor position and large foreign surpluses to default. A strong international financial position makes it unlikely that the government would not be able to attract sufficient demand for its debt from Japanese residents.
Another way to look at this is that a current account surplus means that Japan continues to save more than it invests, and that it consumes less than it produces. Japan’s government debt burden is not a reflection of national financial profligacy. Rather, Japan's government debt burden is a reflection of inter-sectoral financial imbalances. Japan as a whole, the combined government and private sector, is financially on a sound footing. A high level of government debt reflects a high level of government dissaving, which is more than offset by an even higher level of private sector savings.
Put differently, Japan generates sufficient savings domestically to finance government deficits. In principle, this means that the government could simply increase taxes rather than issue debt to the private sector. This makes it unlikely that domestic investors will balk at financing the government. Unless investors come to doubt the government’s political willingness to do so, they understand that economically the Japanese government can always raise taxes to ensure solvency.
Bank of Japan faces difficult balancing act in terms of inflation and deflation
The Bank of Japan will need to be cautious in terms of tightening too much, too early. With inflation declining in the United States and Europe, it does not look like that the recent inflation increase is structural or permanent. Of course, the Federal Reserve and the European Central Bank have increased rates very forcefully, but a case can be made that much of the decline in headline inflation has been due to the sharp decline in energy prices and the normalization of supply chains post-COVID-19. The next few months will provide further evidence in this regard. The Bank of Japan has in fact adopted a wait-and-see approach. It has insisted it needs further data on inflation to decide whether or not to change its monetary policy more forcefully.
The Bank of Japan faces a difficult balancing act. But it is unlikely to feel constrained by Japan’s large government debt burden or concerns about debt sustainability. The challenge the Bank of Japan faces is economic-technical rather than political. If the Bank of Japan reforms its policy framework too quickly by giving its greater policy flexibility, it may trigger policy tightening and expectations about further policy tightening that risk pushing the economy back into deflation. If the bank goes too slow and inflation remains persistently high, it may be forced into too rapid an adjustment of its policy framework, monetary policy and interest rates that risks rippling through domestic and even international capital markets.
This is why the Bank of Japan will go as quickly as it must while going as slowly as it might to exit two decades of unorthodox and largely unprecedented monetary policies. The Bank of Japan will continue to move towards a more flexible monetary policy framework by abandoning both yield curve control and its commitment to a negative short-term policy rate, which would give it the flexibility to move away from quantitative easing, should this ever become necessary. The point is to reform the policy framework so that the Bank of Japan is in a position to deal with both inflation and deflation while limiting the risk that a precipitous policy shift upsets financial markets as well as the risk of increasing deflationary risk by making the framework less rigid. Governor Ueda and his colleagues will need to muster all their experience and skills and most of all sound judgment to navigate the Japanese economy through this challenging time.
H Worries about fiscal dominance and about government debt sustainability are overblown. And even if the Bank of Japan lifts interest rates, Japan will not necessarily be more constrained in terms of fiscal policy and resources, and it certainly will not face debt sustainability issues. If anything, higher interest rates might lead to a decline in asset values, which might cause financial stress, particularly in the financial sector, like what the United States experienced earlier this year. But this is another story. The government will face manageable financial difficulties.
So what?
If, contrary to the argument laid out here, Japan had a debt problem, it would face significant constraints. First, it would have to accept higher inflation, which all other things equal would prove unpopular, as it has done virtually everywhere else, and further undermine the ruling Liberal Democratic Party’s and Prime Minister Kishida’s popularity. And if higher interest rates were to risk putting Japanese government finances on an unsustainable path, Japan would find it more difficult to mobilize the financial resources to support defense spending. Lastly, if Japanese truly risked becoming unsustainable after the Bank of Japan exits unorthodox monetary policies, Japan might sooner or later suffer an economically and financially destabilizing debt crisis, which would weaken its international standing and credibility. Given the present dynamics in East Asia, this could also prove destabilizing geopolitically. As this column has argued, the concerns expressed by some analysts about what higher interest rates might do to Japan’s economic and financial stability and by extension to its geopolitical standing are not warranted.