Japan’s unconventional policy may have passed its use-by date

When the Bank of Japan made what it described as a “technical” change to its monetary policy last month, it thought it had fixed an anomaly in its bond market. Instead, it exacerbated it and brought forward a moment of reckoning for policies that the central bank has adhered to for decades.

The bank’s two-day meeting that got underway today (Tuesday) will have to decide whether to tinker, again, with its yield curve control policy or abandon it, a decision the BoJ had hoped to defer until April, when its longest-serving governor Huruhiko Kuroda ends his 10-year term.

The BoJ is confronted with the same predicament that confronted our Reserve Bank in 2021, when bond investors drove market yields through the 0.10 per cent cap it had imposed on the three-year bond rate. Faced with the choice of throwing billions of dollars at defending the cap – and risking ending up owning nearly all the bonds with that maturity – or ditching the policy, the RBA chose to abandon its short-lived experiment with yield curve control.

Bank of Japan Governor Haruhiko Kuroda stunned everyone before Christmas by widening the trading band on 10-year bond yields.
Bank of Japan Governor Haruhiko Kuroda stunned everyone before Christmas by widening the trading band on 10-year bond yields.Credit:Bloomberg

Japan’s central bank has had a yield curve control policy in place since 2016, alongside its broader and longer-standing quantitative easing (bond buying) policies. The policy, supported by bond purchases, capped its 10-year bond yield at, below or just above zero during that period to try to combat deflation. The BoJ now owns roughly half of all Japanese government bonds.

In December, with inflation in Japan finally rising for the first time in decades, yields on eight- and nine-year bonds traded above the 0.25 per cent cap the BoJ had on 10-year bonds, undermining the effectiveness of its policy.

To straighten out that kink in the yield curve, the bank shocked investors and sent shivers through global markets by raising the cap to 0.5 per cent. Traders and investors had expected that if there were to be any change in monetary policies, it wouldn’t come before Kuroda’s successor was in place.

[Japan’s] status as the world’s largest creditor nation and the largest exporter of capital makes any significant development there of considerable relevance to global financial markets.

If the bank thought that would resolve the issue, it was naive. Last week, yields on the eight- and nine-year bonds again traded above the cap, as did the 10-year bond itself. The bank has spent close to $140 billion since late last week trying to defend its cap.

With the inflation rate in November running at 3.7 per cent, its highest level in more than 40 years, core inflation (excluding food prices) in Tokyo in December at 4 per cent and the first sign in decades of long-sought-after wages inflation emerging, it is inevitable that the BoJ will have to raise interest rates this year. It targets – as do most major central banks – a 2 per cent inflation rate.


The bank could raise the cap again – there are analysts speculating the cap will be raised to 0.75 per cent, or even 1 per cent – but that would only defer the moment of reckoning and again invite trades against the bank. The move could also make the key benchmark for Japanese interest rates, and one central to corporate borrowing costs, irrelevant.

While conniptions in the Japanese bond market might seem of little other than academic interest to those outside Japan, the country’s status as the world’s largest creditor nation and the largest exporter of capital makes any significant development there of considerable relevance to global financial markets.

Japan’s net international investments total more than $US3 trillion ($4.3 trillion). It is the largest holder of US government bonds, with about $US1 trillion of investments. It holds about 8 per cent of France’s government debt, and has major holdings in the UK and Australian governments’ debts.

For most of the decades of Japan’s economic winter and its unconventional monetary policy settings, capital has flowed out of Japan and into international markets in search of positive returns not available in its investors’ home market.

There has also been a decades-long carry trade for hedge funds and traders, who were able to borrow at negligible rates in Japan to fund higher-yielding investments elsewhere.

If Japan’s interest rates rise, the flows of funds would start to reverse and capital would flow out of international markets towards Japan as those investments and trades are unwound. The yen has already appreciated by about 15 per cent against the US dollar since mid-October, suggesting the “Great Unwinding” has already begun.

The December increase in the BoJ’s yield cap triggered volatility across financial markets, with interest rates rising and currencies falling. Another change to the cap could be expected to have similar effects.

In effect, rising interest rates in Japan will tighten global monetary policy by raising rates in other economies as they experience capital outflows. The impact would be exaggerated by the timing of the policy shift, with the US, eurozone and other economies shifting from their post-2008 policies of quantitative easing into quantitative tightening.

Instead of buying bonds they are allowing them to mature without reinvestment, removing the major source of buying and liquidity from their bond markets. The US Federal Reserve Board is now shrinking its balance sheet, which peaked at almost $US9 trillion last year, at a rate of $US95 billion a month.

Japan, the world’s third-largest economy, is itself awash with debt. Government debt was more than 265 per cent of GDP in 2021 and total debt is more than 1300 per cent of GDP. As a reference point, US government debt last year was about 124 per cent of GDP and total debt 768 per cent.

Thus, issues in its bond market — if the inflation Japan is experiencing is something other than transitory and it has to try to back out of unconventional monetary policies that have been in place since the 1990s, designed to address deflationary pressures — could have severe domestic and international repercussions.

The challenge for Kuroda, his successor and a Japanese government that has long pursued aggressively loose fiscal policies will be how to manage the shift from policies designed to fight deflation towards more conventional settings for an inflationary environment without igniting a financial and economic crisis that has spillover effects for the rest of the world.

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Source: Thanks smh.com