Japan ends the world’s greatest monetary-policy experiment

A radical monetary-policy experiment has all but come to an end. On March 19th officials at the Bank of Japan (BoJ) announced that, with inflation of 2% “in sight”, they would scrap a suite of measures instituted to pull the economy out of its deflationary doldrums. The bank raised its key interest rate for the first time since 2007, from minus 0.1% to between zero and 0.1%, becoming the last central bank in the world to do away with a negative-interest-rate policy. It will also stop purchasing exchange-traded funds and abolish its yield-curve-control framework, a tool to cap long-term bond yields. Even so, the BoJ made clear that its stance would remain broadly accommodative: the withdrawal of its most unconventional policies does not augur the beginning of a tightening cycle.

This shift reflects changes in the underlying condition of the Japanese economy. Inflation has been above the bank’s 2% target for 22 months. Data from annual negotiations between trade unions and large firms released last week suggest wage growth of over 5% for the first time in 33 years. “The BoJ has confirmed what many people have been suspecting: the Japanese economy has changed, it has gotten out of deflation,” says Hoshi Takeo of the University of Tokyo. That hardly means Japan is booming—consumption is weak and growth is anaemic. But the economy no longer requires an entire armoury of policies designed to raise inflation. When Ueda Kazuo, the BoJ’s governor, was asked what he would name his new framework, he said it did not require a special name. It was “normal” monetary policy.

image: The Economist

Japan’s economy slid into deflation in the 1990s, following the bursting of an asset bubble and the failure of several financial institutions. The BoJ began trying new tools cautiously at first. Although in 1999 the bank cut interest rates to zero, it lifted them the following year, only to see prices fall again (one of two board members opposed to the decision at the time was Mr Ueda). The BoJ then went further, becoming the first post-war central bank to implement quantitative easing—the buying of bonds with newly created money—in 2001.

Yet it did not fully embrace the wild side of monetary policy until the arrival of Kuroda Haruhiko as governor in 2013. Backed by then-prime minister Abe Shinzo, Mr Kuroda embarked on a programme of vast monetary easing, vowing to unleash a “bazooka” of stimulus. The bank adopted a 2% inflation target and began “quantitative and qualitative easing”, which saw enormous government-bond purchases coupled with aggressive forward guidance (promises to keep policy loose). In 2016 the bank set its key overnight rate at minus 0.1%, meaning that commercial banks were in effect charged for depositing with it, and then implemented yield-curve control in order to restrain longer-term interest rates, too. Although inflation picked up a bit, it never consistently reached the central bank’s target during Mr Kuroda’s term, which ended nearly a year ago.

Officials are now confident that inflation has at last become embedded and the Japanese economy is strong enough to get by without extreme measures. Supply-chain snags and rising import costs pushed inflation up at first, but price rises have since become widespread. GDP growth figures for the last quarter of 2023 were recently revised into positive territory owing to an uptick in capital expenditure.

image: The Economist

The missing piece of the puzzle had been wages. Last year annual wage negotiations produced gains of 3.8%, the highest in three decades. But wage growth still trailed inflation itself, leaving real incomes falling. Then came last week’s blockbuster numbers. They included a big boost to the so-called base-up portion of Japanese wages, which is not linked to seniority. A sustained period of rising prices has emboldened unions to push forcefully for higher pay; Japan’s shrinking labour force is also forcing firms to compete for talent. Policymakers “have been very, very patient, deliberately waiting for the right timing”, says Nakaso Hiroshi, a former BoJ deputy governor. “And now the time is right.”

For such a momentous decision, the short-term impact is likely to be limited. The BoJ had hinted at its intentions ahead of time, meaning markets priced in the move. The yen depreciated slightly against the dollar following the announcement. The bank had already loosened its yield cap last year. Long-term yields have settled at around 0.7% to 0.8%, below the scrapped 1% reference point. Although some Japanese investors may bring funds home as a consequence of the policy shift, global capital flows are unlikely to move drastically, since rates in Japan will still be quite low by international standards, notes Kiuchi Takahide of Nomura Research Institute, a research outfit. Nor will the change to the policy rate have a big effect: under the BoJ’s old framework, there were three tiers of accounts, and the share of funds held in those subject to negative rates was minimal.

The big question is where the BoJ goes from here. Officials have been careful to signal that they are not embarking on a tightening cycle. In a speech last month, Uchida Shinichi, a deputy governor, said there would not be a rapid series of rate rises. Mr Ueda offered few clues about where he suspects rates will settle; most economists reckon they will not exceed 0.5%. The BoJ will also continue buying “broadly the same amount” of government bonds to continue controlling long-term rates. Normalisation of its own balance-sheet will be a gradual process. “The BoJ has left a huge footprint on the market,” says Kato Izuru of Totan Research, a think-tank. “They want to reduce that footprint, but it cannot be reduced suddenly.”

Monetary menace

As the BoJ enters its new era of policymaking, several risks loom. One comes from overseas. If there is a slowdown in America or China, Japan’s two biggest trading partners, it would weigh on external demand and drag down the outlook for Japanese firms, making them less likely to invest.

Another risk comes from within. In the long run, interest payments on Japan’s sizeable government debt will rise, putting pressure on the public finances. The financial system looks sound, but Japan’s financial regulator recently stepped up oversight of regional lenders’ loan books. Many observers are concerned about the impact of rate rises on mortgages and small and medium-sized businesses that do not have large cash buffers.

Most worrying, inflation could fall below target once again. Price inflation, while still above 2%, is already falling. Two doveish board members voted against the decision to abolish negative interest rates, arguing that more time was needed to be sure that inflation will stick. For the trend to continue, Japan needs reforms that raise productivity and boost the potential growth rate, Mr Nakaso argues. If there is one lesson from Japan’s era of monetary-policy experiments, it is that there are limits to central banks’ powers. During Japan’s new era, others will have to take the lead.

Leave a Reply

Your email address will not be published. Required fields are marked *