Japan’s Monetary Balancing Act

Recent inflation has received a much warmer reception in Japan than other developed economies. It now hovers at around 3%, the highest figure since the early 1990s. The Bank of Japan (BoJ) has been locked in a 25-year battle with deflation. Consequently it has not raced to monetary tightening to quell relatively tame figures. But last month, the BoJ started unwinding its most aggressive easing instrument, Yield curve control (YCC). Since 2016, the BoJ has set a hard limit of 1% on 10-year government bonds. Its announcement that this now only constitutes a reference rate sparked investor discussions about a wider policy shift. When will the BoJ abandon negative interest rates?        


In the last week, sentiment has swayed significantly. The yen jumped to a 3-month high against the dollar last Thursday after BoJ governor Kazuo Ueda told the country’s parliament that managing monetary policy “will become even more challenging from the year end and heading into next year”. But hopes of any imminent interest rate rise were dashed soon after by fresh government data showing a sharper than expected third quarter contraction in the Japanese economy. This to and fro reflects the delicate balance policymakers now tread. The country has to pursue monetary policy normalisation while seizing the opportunity for economic recovery. 


There have been promising signs that the economy is finally emerging from decades of lethargy. Foreign investment and wages are on the rise. Investors are bullish about an economy that once threatened US economic dominance. Then, in the early 1990s, Japan’s GDP per capita was 81% of the same US figure. Today, it is 64%. After the “lost decade” that precipitated this fall, policymakers fear tightening at the wrong moment. BoJ board member Toyoaki Nakamura has talked of the need to eradicate Japan’s deflationary mindset. “The key is for the economy to keep recovering”, he said earlier this year.  

However, extraordinary measures cannot be used continuously and Japan seeks a return to long-term sustainable growth. Former BoJ board member and economics professor, Sayuri Shirai, describes the challenge as “enormous”. She says Japan must “correct the extreme depreciation of the yen – without causing significant damage to markets, while also committing to a 2% inflation target…Given rising government and corporate debt, a rapid interest rate hike is likely to cause significant stress to the economy.” While the weak yen has provided some benefits for Japan’s export-led economy, these are limited by the international nature of most Japanese production. But a sudden rise in interest rates to levels of its international counterparts will significantly increase borrowing costs for a highly indebted government. BoJ policy must enable a level of growth that makes this debt sustainable. 


The BoJ also wants to shift its massive holdings of government debt. Japanese investors are currently the biggest foreign owners of US Treasuries. The BoJ wants to motivate domestic investment instead. To do so, it will need to make this debt attractive to Japanese institutions. Raising interest rates is an obvious way to do this but it creates problems for government borrowing as outlined above. Also, significant rises may in fact disincentivize what some investors predict will be a “great repatriation” of Japanese investment flows.  

The Economist’s Asia business and finance editor Mike Bird explained why in a recent episode of “Money Talks”. While US Treasuries represent a much higher-yielding asset than Japanese government bonds, the current cost of currency hedging eats into these returns. Japanese investors borrow in USD and are exposed to these higher levels of interest rates. Once these hedging costs are baked in, the overall returns from lower-yielding Japanese bonds often constitutes a sounder investment. Higher Japanese interest rates would mitigate these hedging costs and, at too high a level, make US Treasuries more attractive to Japanese investors. Therefore, as the BoJ tries to offload this debt, it needs to set rates at a level that takes advantage of this phenomenon in its domestic market. 


The BoJ cannot therefore make these decisions in international isolation. Much will depend on the Fed’s policy decisions. In the bond market scenario, further Fed tightening would allow the BoJ to act similarly without jeopardising the advantages of lower interest rates. It would also likely force the BoJ to do so to prop up the struggling yen. Tuesday’s figures showed a rise in US core inflation, highlighting its stubborn nature in the economy. While that has not changed expectations that rate rises there are finished for now, it dampens expectations of cuts early next year.        


Japan’s unique economic challenges will force the BoJ to pursue a bespoke path to economic recovery. Mike Bird points out that “falling interest rates helped to cushion a 30-year buildup of government debt in Japan. But the debt pile is now so large that even very small increases in bond yields and benchmark rates will mean an extensive fiscal squeeze.” Increasing costs of government borrowing are an international issue. But Japan faces the greatest pressure amongst developed economies not to choke resurgent growth in confronting this problem. 

Perhaps with one eye on a 2024 election, Prime Minister Fumio Kishida recently announced a US$113bn stimulus package. It’s uncertain how this loose fiscal policy will square with prospective monetary tightening. For investors, it makes next year’s BoJ decisions all the more opaque. Get these right and those bullish on Japan will be rewarded. Get it wrong and it will not be the first time the BoJ is knocked off course by badly timed tax rises. 



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