Bank of Japan Takes a Small Step in the Right Direction

Tokyo took centre stage on Tuesday, as the Bank of Japan (BoJ) raised its benchmark interest rate from -0.1% to 0% – 0.1%, concluding its 8-year experiment with negative rates.^[i] It also partially ended its Yield Curve Control (YCC) programme, through which it used purchases of Japanese Government Bonds (JGBs) to keep 10-year yields at or near a set rate. Now, it is abandoning rate targets but continuing to buy JGBs at a fast clip.^[ii] We don’t think any of this means much for markets, which we think long ago priced in a widely discussed move. But in our view, the partial return to normal monetary policy is no bad thing.

Japanese banks have long bemoaned negative rates, which are essentially a tax on holding cash.^[iii] Whilst theory says this is an incentive to spend and invest instead of hoarding, banks—rightly, in our view—noted that taxing reserves whilst whacking loan revenues by forcing down long rates was a massive disincentive to lend.^[iv] This meant less capital flowing through Japan’s economy than might otherwise have been, which our research shows is a headwind to growth—the opposite of the intended stimulus. In our view, bringing rates back above zero is a small but important step to restoring more traditional incentives.

Yet as long as the BoJ keeps meddling with long rates, we don’t think the return to normal is complete. Ending YCC is technically a step, we guess. The official cap on 10-year JGB yields had already risen from 0.1% to 0.25%, then half a percent, and most recently 1.0%.^[v] Past ceilings lifted as markets tested the BoJ’s resolve to defend its peg, and at each turn it caved eventually. Now, as it abandons explicit target rates, the 10-year JGB trades at 0.73%.^[vi] We have seen a lot of talk about how this means the BoJ successfully normalised the yield curve, leaving the impression markets are now in charge.^[vii]

But this seems off to us, because the overarching quantitative easing (QE, the purchasing of government debt securities and other long-term assets from banks to reduce long-term interest rates) programme continues, with the BoJ pledging to continue buying ¥6 trillion (£31.3 billion) of JGBs per month.^[viii] So in a way, we think this new approach simply gives markets less clarity—we know the BoJ will be buying JGBs, but seemingly at arbitrary maturities to manipulate yields as it sees fit. It will still be exerting downward pressure on long rates, which will likely still interfere with lending incentives since long-term bond yields are typically a reference rate for consumer and business loan rates. In other words, we think this is still a case of the (metaphorical) monetary beatings continuing until morale improves. On the bright side, our research suggests markets are well used to this, and Japanese gross domestic product (GDP, a government-produced measure of economic output) has proven it can grow alongside suboptimal policy, so we don’t view it as a massive cyclical headwind.^[ix]

In our view, there are also some international implications here. For the past few years, Japan has seemingly served as a real-life counterfactual for Western monetary officials’ rate hikes. As the only monetary policy institution not raising rates, the BoJ created a control group for how inflation (broadly rising prices across the economy) evolved without fast-rising short rates. Turns out it evolved just fine, slowing from a high of 4.4% y/y in January 2023 to 2.1% in January 2024.^[x] Yes, even without rate hikes, the inflation rate more than halved as supply chains improved and energy prices eased.^[xi] Services prices, which are currently the focus of many Western economic commentators, never really spiked in Japan—they just finally escaped deflation, gradually crawling to 2.2% y/y in January.^[xii] Japan’s experience strikes us as one more piece of evidence inflation in the US, UK, Europe, Canada and Australia improved despite rate hikes, not because of them—a point commentators we follow are starting to argue lately, which we find refreshing.

As for Japan, whilst Tuesday’s move appeared to be welcome news for businesses all over the country, judging from the range of responses included in coverage of the bank’s decision, we don’t think it alters the country’s fundamentals. The long-running divide we have observed between domestically focussed businesses and export-rich multinationals probably continues, with external demand being a big economic driver. The yen is still at generational lows, trading near ¥150 to the dollar, which lets exporters reap profits from converting overseas sales revenues back into yen, but it extends headwinds on companies that import components, resources and labour.^[xiii] Winners and losers, as we find is the case with most currency moves. But in our view, it all amounts to extending the long-running status quo, just with a little less funky BoJ policy than the country had on Monday.