Last month, the Bank of Japan took its first important step toward monetary-policy normalization. The BOJ ended its negative interest-rate policy, setting the policy rate between 0.0 percent and 0.1 percent. It abandoned yield-curve control, which had been introduced to keep the ten-year government bond yield around 0 percent. And it announced that it would taper off new purchases of exchange-traded funds and real-estate investment trusts, but maintain the current pace of government-bond purchases. It amounts to a momentous macroeconomic shift.
The change comes after more than a decade of super loose monetary policy by the BOJ. In 2013, then-Prime Minister Shinzo Abe introduced an economic policy package aimed at reinvigorating the economy after prolonged economic stagnation and deflation. Within the first four months of that year, the BOJ had adopted a 2 percent inflation target and launched quantitative and qualitative easing (QQE). Almost immediately, the inflation rate turned positive, the yen depreciated sharply, and stock prices started to climb. Moreover, thanks to QQE, business conditions gradually improved, unemployment fell, and the gap between actual and potential GDP narrowed.
But inflation remained below the 2 percent target for years, not least because firms worried that raising prices (both wholesale and retail) would alienate their customers. After all, Japanese consumers had grown accustomed to deflation, and despite the BOJ’s announced target, inflation expectations remained stuck at zero. Even in 2019, when the Japanese economy was plagued by labor shortages, the inflation rate remained below the target, and wages did not rise significantly.
It was only after the COVID-19 crisis that this changed. At first, pandemic-related restrictions caused aggregate demand to fall sharply, weakening inflationary pressures. But when the restrictions were lifted, demand surged, with inflation hot on its heels. Russia’s full-scale invasion of Ukraine stoked inflation further, by driving up energy and commodity prices. Suddenly, inflation was running at 4 percent in Japan -- far lower than the rates in the United States and the European Union, but very high by Japanese standards.
And yet, the BOJ did not rush to start tightening its monetary policy -- it maintained QQE throughout 2022-23 -- for two reasons. First, the inflationary surge was widely considered to be transitory, because it was driven by temporary supply-side factors. Second, the BOJ hoped that this bout of above-target inflation would raise inflation expectations above 0 percent. This aligned with its 2016 “inflation-overshooting commitment,” asserting that the monetary base should expand until core inflation was running above 2 percent in a stable manner.
Japan may have reached this point. In the fall of 2023, the inflation rate had been above 2 percent for more than a year and a half; the core-core consumer price index (the inflation rate, excluding energy and fresh food) surpassed headline inflation, and inflation expectations had begun to rise. By December, BOJ Governor Kazuo Ueda and his deputy governors and policy board members were suggesting that, if the 2024 “spring offensive” (pay-raise season) brought substantial wage increases, the first step toward normalization might be imminent.
This condition seems to have been met. As of March 15, the average wage hike was 5.28 percent. When tenure-based wage increases are stripped out, that figure falls to 3.7 percent -- still more than enough to compensate for inflation. With a new equilibrium of 2 percent inflation, 2 percent expected inflation, and 3 percent wage growth in sight, the BOJ followed through on its pledge. And, so far, no risks have materialized: the yen has not appreciated, and stock prices rose -- not the usual (negative) market reaction to monetary tightening.
Does this mean the BOJ is likely to continue on this path, hiking the policy rate to 0.25 percent, then 0.5 percent, and maybe even to 1 percent by the end of this year? The answer will depend on inflation data. If actual and expected inflation converge at 2 percent, and remain anchored there, a gradual increase in the policy rate is likely. But it is too early to predict macroeconomic conditions for the rest of the year.
Suppose macroeconomic conditions do spur the BOJ to continue raising the policy rate, and the yield curve becomes steeper. What risks would arise?
First, if the long-term interest rate increases sharply, the mark-to-market valuation of long bonds as financial institution assets might fall significantly. That is what happened to Silicon Valley Bank last year, though a run on deposits like the one that led to SVB’s collapse is unlikely to occur in Japan. While some regional banks in Japan hold long-maturity bonds, most are well-capitalized, and a 1-2 percent increase in the long bond rate might not amount to much of a shock, anyway.
Second, an increase in the long-term interest rate will increase the costs of servicing Japan’s national debt. As more money is allocated to interest payments, less will be available for other kinds of fiscal spending, such as for education, infrastructure, and defense. Spending cuts on social security, in particular, would be politically very difficult in Japan, where the median age exceeds 49 years.
A third risk is that the BOJ’s profits could turn negative. The BOJ has announced that it will start paying 0.1 percent interest to current account balances, including its holdings of banks’ excess reserves. As the interbank rate fluctuates between 0 percent and 0.1 percent, the remunerated reserves essentially provide a subsidy to commercial banks. And it will be expensive: 517 billion yen ($3.3 billion) in 2024, compared to 183 billion yen last year. This is still small enough that the BOJ would report surpluses -- unless it hikes its policy rate to 1 percent before it shrinks its balance sheet.
The first step toward monetary policy normalization went smoothly, and it is entirely possible that the next one will, too. But there are plenty of challenges ahead for the BOJ.
Takatoshi Ito
Takatoshi Ito, a former Japanese deputy vice minister of finance, is a professor at the School of International and Public Affairs at Columbia University and a senior professor at the National Graduate Institute for Policy Studies in Tokyo. The views expressed here are the writer‘s own. -- Ed.
(Project Syndicate)
