What the Bank of Japan is trying to do

Japan might be eight hours ahead, but in monetary policy terms, it is two years behind the UK. Its policy rate has sat unchanged at -0.1 per cent since 2016 (see chart), and economists are split on whether the Bank of Japan (BoJ) will even consider interest rate hikes next year. Why has Japanese monetary policy taken such a different path? 

Stubbornly low inflation

Like the Bank of England, the Fed and the European Central Bank, the BoJ has a 2 per cent inflation target. But unlike these other central banks, the BoJ is worried about undershooting it. Japan’s deflationary period ended a decade ago, but since 2013 inflation has averaged just 0.8 per cent. It is around 3 per cent today.

After the last policy meeting, BoJ governor Kazuo Ueda said “although some companies are starting to become more aggressive in their wage and price setting behaviour than before, we have not reached a situation where we can foresee the sustainable and stable realisation of the price stability goal.” Services inflation remains low, and much of the recent uptick in inflation has been driven by higher core goods prices. 

What is the policy stance?

The BoJ has engaged in a three-pronged attack to tackle this persistently low inflation. Interest rates have been below zero (under the stated ‘negative interest rate policy’, or NIRP) since 2016 and still sit at -0.1 per cent today. This very accommodative stance has been supported by qualitative and quantitative easing – the less familiar ‘qualitative’ part referring to policymakers purchasing privately held risky assets and replacing them with government debt. The third prong is yield curve control (YCC), which allows the BoJ to target longer-term interest rates. 

Under YCC, the BoJ has pledged to buy enough 10-year Japanese government bonds to stop yields from rising above its target. Initially, YCC operated with a zero per cent target with a very low tolerance of plus or minus 0.2 per cent, which was expanded to 0.5 per cent last December. 

In July, the BoJ raised the ceiling at which it would conduct bond purchases to 1 per cent, effectively expanding its tolerance again. Economists note that this marked a significant policy development. Following the announcement, Marcel Thieliant, head of Asia-Pacific at Capital Economics, said the move meant that YCC was effectively over: “Developments over the past year have demonstrated that the BoJ will widen its tolerance band whenever yields push up against the ceiling for a prolonged period,” he said. 

Will the BoJ hike rates at all?

Will more policy change follow? The route out of yield curve control is unclear. Capital’s Thieliant warns that dismantling the policy completely would see the BoJ reduce its holding of Japanese government bonds, which could depress prices and push up yields. 

The impact could “raise questions about the sustainability of Japan’s very high public indebtedness”, and also threaten valuation losses at insurance firms and pension funds which hold large amounts of Japanese government bonds. As a result, the BoJ might begin by widening its tolerance band further if yields push up against the ceiling again. Analysts at Societe Generale think the ceiling could rise to 1.5 per cent in January 2024. 

NIRP’s days could also be numbered. Seventy per cent of economists anticipate that the BoJ will end its negative interest rate policy next year – but hikes are likely to be far less vertiginous than we have seen elsewhere. Capital Economics expects the central bank to raise rates to 0.1 per cent in January, while Barclays economists only expect a hike in April, once policymakers know the outcome of spring wage negotiations. Economists at Societe Generale doubt that underlying inflation will be strong enough to convince the BoJ to raise rates at all in 2024. Rather than catching up with the hiking cycle, we might find that the central bank sits this one out.