While almost every major central bank worldwide has been trying to keep up with the Federal Reserve regarding rising interest rates to limit the raging inflation, the Bank of Japan (BoJ) seems reluctant to change its already decades-long expansionary policy. The following article examines the possible reasons for the BoJ's decision and the constraints on such a policy in the long run.
Bank of Japan – the last man standing
While almost every major central bank worldwide has been trying to keep up with the Federal Reserve regarding rising interest rates to limit the raging inflation, the Bank of Japan (BoJ) seems reluctant to change its already decades-long expansionary policy. The following article examines the possible reasons for the BoJ's decision and the constraints on such a policy in the long run.
Summary
- Bank of Japan has kept interest rates low for over two decades to boost its economy and fight deflation.
- To prevent yields from rising outside the range of its yield curve control policy, the BoJ has bought more than half of all outstanding government bonds, pushing the country's debt to over 234%.
- As investors have the opportunity to invest in higher-yielding instruments outside Japan, its national currency is losing value amid low demand and a strong US dollar.
- Despite the inflation finally reaching its target, BoJ is not rushing to abandon its ultra-accommodative monetary policy, arguing that this is not the inflation they hoped for.
BOJ's ultra-dovish policy
Japanese 10-year bond yield has been below 2% since 1997 and below 1% since 2012. In September 2016, the BoJ implemented the Yield Curve Control (YCC) to prevent the 10-year bond yield from turning deeply negative, fight deflation, and protect the fragile banking sector. The YCC policy committed to keeping the bond yield around zero, which afterwards was raised to 0.1% and, later, to a 0.25% range. The policy has been implemented through bond market transactions. Over time, the focus of the YCC policy changed from preventing negative yields to capping the growth of the yields.
In December 2022, in response to the markets pushing the bond yields higher, BoJ announced that the 0.25% cap on yields would be replaced by a higher and more defensible 0.50% cap. This step was broadly perceived by investors as a sign of BoJ slowly waiving the ultra-dovish monetary policy, pushing the 10-year government bond yield to BoJ's upper yield cap.
Source: Tradingeconomics.com
The BoJ's YCC policy has not come without a cost. Below we look at some side effects of an expansionary policy, such as the growing government debt and its impact on the national currency.
Japan's enormous government debt
As more and more investors bet that the BoJ would abandon its YYC policy, the central bank seems finding it increasingly difficult to keep the yield on the 10-year government bond within its target range.
Since the yield and price of a bond are inversely related, a rising yield means a falling price. This means that in order to defend the yield ceiling, the BoJ has to buy its government bonds in large quantities. As a result, the BoJ owns more than half of Japanese government bonds.
In January, the yield on 10-year Japanese government bonds exceeded the BoJ's cap of 0.5% and rose to 0.505%. In response, the BoJ purchased 300 billion yen (2.2 billion USD) worth of Japanese government bonds with 5- to 10-year maturities and 100 billion yen worth of bonds with 10- to 25-year maturities. In its struggle to restrict elevated yields, the BoJ purchased a record 23.69 trillion yen (175.69 billion USD) worth of government bonds in January.
While nearly 24 trillion yen seems like an enormous amount of funds, it is just a drop in the ocean compared to Japan's total government debt. With government debt surpassing the 1,000 trillion yen or 8 trillion USD (depending on the exchange rate) threshold, Japan is the most indebted country in the world, with the government debt-to-GDP ratio surpassing 234%. For comparison, in a well-known country for its government debt – the US – this ratio is a mere 126.7%.
BoJ policy's impact on the Japanese yen
Japan and its central bank have been fighting deflation for decades, doubling the supply of the Japanese yen since the beginning of the century in an attempt to stimulate economic activity that would lead to inflation. Until March 2022, Japan was unable to achieve its 2% inflation target, and the yen had to absorb the increased money supply in the economy.
In 2022, the Japanese yen, along with many other currencies, lost ground against the aggressively appreciating US dollar and has since been unable to return to its former level of around 110. One of the reasons for the Japanese yen's struggles (in addition to the US dollar's appreciation) is that investors have plenty of opportunities to seek higher-yielding assets around the world as an alternative to Japan's negative-yielding government bonds, leading to a decline in demand for the currency.
Source: TradingView
The tight relationship between interest rates and the national currency may be seen in the USD/JPY exchange rate. Following the BoJ's announcement of broadening the yield band cap to 0.50% in December 2022, the Japanese yen increased by nearly 4%, resulting in its largest daily gain against the US dollar this century. It didn't take long for the BoJ to refute all the speculations about dropping their ultra-accommodative interest rate policy, which again made the yen depreciate as much as 2.7% against the US dollar in mid-January.
If the yen weakens, it may create a dangerous cycle for the country. Imported energy and commodities from the US, denominated in US dollars, would become more expensive, amplifying the Japanese trade deficit. This has been the case since August 2021, as the trade deficit has grown monthly. Furthermore, with much of the manufacturing sector now located outside of Japan, the weaker yen no longer stimulates exports or benefits factory workers with higher wages. This, in turn, has led to stagnant wages and weak consumption – factors that do not lead to inflation.
While BoJ is generally believed not to intervene in foreign exchange markets, BoJ's officials have announced that they are ready to stem the yen's volatility at any moment. Such a moment appeared on Thursday, September 22, last year, when the USD/JPY exchange rate surpassed the 145 level – the lowest value for the yen in 24 years. In response, BoJ intervened and sold US dollars to stop further depreciation of the national currency.
Japan vs inflation
Japan is now facing something that has been wished for since the introduction of ultra-accommodative monetary policy years ago - inflation has finally reached (and exceeded) its target. It could be argued that this might be the right time for the BoJ to abandon its expansionary monetary policy, raise interest rates and provide some much-needed support to its currency.
It may seem that the BoJ has reasons to think otherwise. Japan wants inflation to be driven by healthy consumer demand. Instead, however, it has been hit by inflation caused by a strong US dollar and by supply shortages due to the pandemic and the war in Ukraine. This has led to a divergence in monetary policy between the US and Japan, with investors seeking higher yields elsewhere, further weakening the yen.
In the US, the Fed seeks to reduce inflation through higher interest rates and, therefore, lower consumer demand. Meanwhile, Japan has only just returned to pre-pandemic levels, and wages have been stagnant despite the unemployment rate below 3%. Inflation in Japan has been driven largely by external factors (producer prices have grown nearly 10% over the past year). Still, companies are resistant to passing them further to customers keeping the inflation rate relatively low. Companies have felt a sense of loyalty to their customers and are worried that they may lose business if they make their products more expensive. Even when input costs rose, many firms chose to take the hit in profit margins rather than passing the cost on to their customers.
The BoJ has no control over the appreciation of the US dollar and supply shortages, as these are external factors. This means that raising interest rates at this time would not only have any noticeable effect on inflation but would also put additional pressure on Japanese companies, which are already struggling with higher costs.
Conclusion
While Japan may have well-grounded justification for not abandoning its low-interest rate regime in terms of inflation, one has to wonder if it does not give more harm in terms of weak national currency and growing debt. The markets are closely watching the BoJ's actions, mainly because the new BoJ governor is set to start his work next month.
Santa Zvaigzne-Sproge, CFA, Head of Investment Advice Department at Conotoxia Ltd. (Conotoxia investment service)
Materials, analysis, and opinions contained, referenced, or provided herein are intended solely for informational and educational purposes. The personal opinion of the author does not represent and should not be constructed as a statement, or investment advice made by Conotoxia Ltd. All indiscriminate reliance on illustrative or informational materials may lead to losses. Past performance is not a reliable indicator of future results.
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