Bank of Japan (BoJ) ends negative interest rate and yield curve control policies in order to regain greater monetary policy flexibility rather than to tighten monetary policy to maintain price stability, which will nevertheless benefit the Japanese banking sector financially. On March 19, the BoJ announced that it would exit its negative interest rate policy and end its yield curve control policies, marking the first time in 17 years that it increased the interest rate. The BoJ expressed hope that it can sustainably reach its two-percentage inflation target in light of favorable recent wage growth dynamics. The BoJ also did away with its multi-tier deposit policy, which had helped shield banks from the effects of negative interest rates. The central bank also announced that will continue to intervene at the long end of the curve to prevent a spike in interest rates and it will continue its policy of buying JPY 6 trillion worth of government bonds a month, though the governor stated that “at some point” the bank planned to lower the amount of JGB purchases. Finally, the BoJ said it will refrain from purchasing ETFs and REITs. The decision to reform the operational framework and raise short-term interest rates was taken in the context of rapidly declining inflation but unusually strong wage inflation.
The central bank raised its main policy rate to 0-0.1% and simplified the previous multi-tier deposit rate system. It also abolished its long-standing yield curve control policy, which had been in place since 2016 and which the BoJ had modified several times in the 11 months since Ueda came to office. In October, the BoJ modified its yield curve control policy by switching from a 1% ceiling (with a 0.5%-point band) on ten-year government bond yields to a reference rate. Year-on-year inflation declined to 2.2% in January from 2.6% in December. Core inflation fell from 2.3% to 2%, down from 2.5% in November, registering the third month of consecutive decline. The BoJ’s inflation target is 2%. Last week, Japan’s biggest companies agreed to a major wage increase of 5.3% for 2024, the largest pay increase in more than 30 years.
The BoJ has been keen to exit unconventional policies to provide the central bank with greater policy flexibility in case of another surge in inflation. The BoJ was caught on its backfoot following the 2021-22 supply-side and currency-driven inflation surge. The March 19 monetary policy adjustment and reform of the bank’s operational framework will give it more flexibility to respond to price shock. Recent inflation dynamics raise doubts as to whether monetary policy tightening was necessary. Both headline and core inflation have been declining. The Bank itself seems to harbor doubts as to whether it can reach its two-percent inflation target on a sustainable basis. With inflation falling, this was perhaps the last opportunity to exit its unconventional policy. Tightening policy while inflation is running below target would have been a harder sell. At the very least, the inflation outlook remains highly uncertain. The size of the interest rate adjustment and the fact that the BoJ will continue to buy Japanese government bonds suggests that the BoJ is equally uncertain.
Japanese core inflation peaked at a multi-decade high of 4.2% in January 2023. In January 2024, it fell to 2%. The combination of declining inflation and accelerating wage growth in the context of subdued economic activity create a very uncertain outlook for future price dynamics. Structurally, there is very little reason to expect an acceleration of inflation, not least because much of Japan’s inflation was largely due to a weak exchange rate, higher import prices and COVID-19 related supply chain disruption, all of which are transitory. Although the BoJ exited its yield curve control policy, it will continue to buy JPY 6 trillion worth of government bonds a month and it will stand ready to intervene in case long-term yield spikes. This suggests that the BoJ recognises the need to maintain policy flexibility to self-insure against future disinflation rather than inflation.
The macroeconomic impact will be limited, but the Japanese banking sector is set to benefit from greater profitability on account of higher interest rates. The end of negative interest rates will help boost Japanese banks’ profitability and share prices. Meanwhile, the Japanese yen remains at multi-decade lows, but this is largely due to high U.S. interest rates and recent revisions of how quickly the Federal and by how much the Federal Reserve will lower interest rates this year. The ten basis point increase in Japanese short-term rates will have a negligible impact on the continued large US-Japanese interest rate differential. Once the interest rate differential narrows, the Japanese will appreciate and lead to lower import prices, which will exert further downward pressure on inflation. The risks to medium-term inflation are weighted to the downside, particularly once the Fed begins lowering interest rates. Finally, higher nominal interest rates, including higher long-term interest rates, would increase the government’s debt servicing costs. However, a ten basis point increase on the short end will make little difference. Meanwhile, ten-year yields have increased from virtually zero to 0.7%. However, this increase is more than offset by higher inflation and higher nominal GDP growth. A change in nominal interest rates will only negatively affect medium-term government debt dynamics if it translates into increasing real interest rates. In the short term, the BoJ’s decisions will have a very limited impact on debt dynamics. Much will depend on where real interest end up, and this is a function of both interest rates and inflation.
The Japanese equity market index is near all-time highs, largely on account of a weaker yen, higher inflation and (maybe) recent corporate corporate reform. The shares of Japan’s largest banks have rallied as much as 80% over the past two years due to an improving outlook for profitability due to higher nominal interest rates. The Japanese yen remains near more than thirty-year lows against the dollar due to the large US-Japanese interest rate differential. The BoJ’s short-term rate is 0-0.1%, the Fed funds rate is 5.25-5.5%. Japanese ten-year government bond yields remained virtually unchanged at below 0.8%, roughly the same level as a month ago. Equivalent U.S. yields are 4.3%.