Why Japan is forced to take baby steps to normalise monetary policy

Japan’s central bank ending its negative interest rate regime comes not a moment too soon, but that alone will not return the economy to its heyday
Uncertainty over the outlook for growth and inflation persists, and the internal issues that led to the adoption of ultra-loose policy are still in place

Nicholas Spiro

Published: 4:30pm, 21 Mar 2024

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The odd one out in global monetary policy is returning to the fold. On March 19, the Bank of Japan (BOJ) took the first step in ending an unprecedented era of cheap money when it jettisoned its eight-year-long negative interest rate policy, raising borrowing costs for the first time since 2007 and scrapping several other measures that were introduced in an effort to vanquish deflation.

The BOJ also ditched its policy of capping the country’s 10-year bond yield at 1 per cent and will no longer purchase exchange traded funds and real estate investment trusts. Symbolically, the return to positive borrowing costs is a landmark event in Japan’s decades-long efforts to undo the damage wrought by the bursting of the late 1980s asset bubble.

The end of the negative rate regime – a radical, albeit controversial, policymaking tool that might have helped prevent deeper deflation but crushed financial institutions’ interest income – comes not a moment too soon. Doubts over the efficacy of the policy intensified in recent years, especially when inflation began to rise sharply because of the supply shocks triggered by the Covid-19 pandemic and Russia’s full-scale invasion of Ukraine.

The signalling effect of the BOJ’s policy shift is highly significant. Not only does it indicate the central bank is increasingly confident it can hit its 2 per cent inflation target in a sustainable manner, it underpins a dramatic rally in Japanese equities that caused the Nikkei 225 index to surpass its bubble-era peak last month.

Foreign investors, who are driving the stock market rally, are convinced Japan is back. The decision by the country’s largest companies earlier this month to award workers their biggest pay rise since 1992 was a crucial factor in the BOJ’s decision and is one of the reasons market sentiment is bullish, along with shareholder-friendly corporate governance reforms and geopolitical realignments working in Japan’s favour.

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In a report published on March 19, Morgan Stanley said the BOJ was able to call time on “exceptional monetary policy accommodation” because of “a much-improved macroeconomic environment” characterised by “a virtuous cycle of rising nominal GDP growth, wages, prices and corporate profits”.

Not so fast. While Japan will remain Asia’s “market of choice for investors”, in the words of Bank of America, uncertainty over the outlook for growth and inflation persists. The BOJ was at pains to stress that its exit from ultra-loose policy will be gradual and cannot be compared with the sharp increases in borrowing costs undertaken in the United States and the euro zone.

The central bank has said there were “extremely high uncertainties surrounding economic activity and prices” that warranted keeping financial conditions accommodative for some time. Japan will have enough problems normalising interest rates, never mind tightening policy.

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First, the rise in the BOJ’s benchmark rate from minus 0.1 per cent to a range of zero to 0.1 per cent, coupled with the decision to keep the central bank’s bond-buying programme in place, attest to policymakers’ concerns about moving too fast. While there is a possibility of a sharper-than-expected wage-price spiral, the bigger threat is that growth and inflation prove weaker than anticipated.

External factors, not domestic ones, were behind the sharp increase in inflation. Japan only narrowly avoided falling into recession at the end of last year. Consumer spending – the key ingredient for self-sustaining growth – declined at a faster pace in the final quarter of 2023 thanks to the continued inflation-fuelled erosion of households’ purchasing power.

Second, Japan still suffers from the structural problems – demographic decline, the highest public debt burden in the developed world and persistently weak growth – that led to the adoption of ultra-loose policy in the first place. The International Monetary Fund expects the economy to slow this year amid a fade in the one-off factors that supported growth in 2023, including a surge in inbound tourism.

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Third, even the most encouraging developments, such as wage growth, should be treated with caution. Although big companies have granted workers large pay rises, small and medium-sized firms, which are the backbone of Japan’s economy, have yet to follow suit. Broad-based wage growth is needed in order for policy normalisation to gain momentum.

Fourth, the BOJ ended negative rates at an opportune moment, when the gap between Japanese and US bond yields remains wide, maintaining downward pressure on the yen and contributing to inflation. However, when the US Federal Reserve starts cutting rates, the gap will begin to narrow, increasing the likelihood that the yen will strengthen and endangering reflation.

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This will be the moment of truth when it becomes clear whether the domestic forces of reflation are strong enough for policy to become less accommodative. While deflation has been overcome, the task of normalising policy could prove more difficult.

Jesper Koll, publisher of the Japan Optimist newsletter, noted that while defeating deflation was the “overarching mission until now”, the challenge facing the BOJ in the coming months is to normalise policy “without really knowing what normal is or how best to get there”.

What is clear is that Japan has little choice but to proceed cautiously in its exit from unconventional policy. That negative rates are now a thing of the past is a huge milestone, yet the road to policy normalisation will be a long and bumpy one.

Nicholas Spiro is a partner at Lauressa Advisory

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