For a decade I was Chief Economist at Japan’s DKB International, when Dai-Ichi Kangyo was the biggest bank in the world. I covered Japan closely, called Japan’s lost decade correctly, including the decline in rates and yields, was asked to write a regular column in the Nikkei Weekly and met regularly with Japanese policymakers.
During my time there, I saw the Nikkei stock market peak in December 1989 (at a level it did not surpass again until this February), Japan’s economic bubble burst, land prices began a fall that lasted a quarter of a century and the collapse of Yamaichi Securities in 1997 (then one of the biggest financial firms in the world).
The euphoria that one could almost touch on visiting Tokyo was replaced by a sense of impending doom. Pessimism persisted for decades, and it has only been in the last couple of years that signs of recovery have become evident. In turn, business confidence has rebounded, profitability has increased and – crucially for the BOJ – fears of deflation have been replaced by expectations of rising inflation.
The BOJ has a 2% target for inflation, with expected inflation rates having already exceeded 1%. One of the contributing factors to the BOJ moving in March was the spring pay round – the shunto – which saw a rise of 5.28% for large firms, the largest wage rise in 33 years.
It may seem odd to view rising inflation as a positive, but when the rise is relatively low and the alternative has been a fight to prevent deflation one can understand. Deflation encourages people and firms to delay purchases in the expectation that prices will be lower, it eats into profit margins and forces cost cutting. Also, it added to concerns about Japan’s debt burden, as government debt levels have soared in recent decades to over two and half times the size of GDP.
If one can point to a turning point in Japan it was in the aftermath of the December 2012 election. Then Japan embarked upon Abenomics, under Prime Minister Abe, with a combination of structural reforms, fiscal stimulus and monetary easing. In April 2013, for instance, the BOJ introduced Quantitative and Qualitative Easing (QQE) and in January 2016 it took unconventional monetary policy one step further with a move to negative interest rates. This included three tiers of interest rates for banks and financial institutions, and crucially it set the key policy rate at minus 0.1%.
Hence the significance of the decision by the BOJ this week, when it raised its policy rate for the first time in 17 years, since February 2007. It moved rates out of negative territory, from minus 0.1% to zero, to a new rate of zero to plus 0.1%. A small move for the central bank, but it could be a giant move for the economy especially if it helps cement an improvement in business and consumer confidence. Japan’s population is ageing and shrinking. The trend rate of economic growth has already slowed. But the BOJ is signalling that deflation is no longer the worry.
Policy may no longer be super loose, but it is still loose. Hence a focus on what the BOJ will do next, as its unconventional stance had also seen its balance sheet soar, with the central bank supporting the equity and bond market in Japan. This week it signalled its gradual exit from these areas of policy, too, but this is likely to take a considerable time.
In addition to its rate decision the BOJ made a series of other important announcements. It will also no longer control bond yields through yield curve control, which had kept 10-year yields at around 0%. The BOJ also announced it would no longer use its presently bloated balance sheet to buy risk-assets, such as exchange traded funds and real estate investment trusts. It will, though, still buy sizeable amounts of government bonds.
The future direction of rates will be one of many issues likely to dominate market sentiment, as will be the implications for bond yields and for the yen.
As a consequence of its unconventional monetary policy, the BOJ has displaced Japanese institutional investors as the biggest holder of Japanese Government Bonds (JGBs). The latest data shows that at the fiscal half-year, last September, the BOJ held Y 574 trillion, almost 54% of the total. The scale of its holdings suggests the BOJ will have to move gradually as it reduces its bond holdings. If not, then the bond market would face a major shock.
The implication is a gradual upward move in yields, although the BOJ’s actions will be aimed at preventing a sharp rise in yields. A scenario by the Cabinet Office, for instance, believes that if growth is strong then long-term interest rates will rise from 0.6% in fiscal 2023 to 1.5% in fiscal 2028 and that in this scenario the annual interest rate bill on government borrowing would rise from Y 7.6 trillion to Y 11.5 trillion. As the BOJ buys less, yields will likely rise, to attract new buyers and more buying from Japanese institutions, and in the process add to debt servicing costs.
Another focus is the yen. Although the markets have been focusing on the BOJ’s potential exit from super loose monetary policy for some time, the yen has continued to weaken. In part that is because monetary policy has been tightened significantly elsewhere, not least in the US. The BOJ has previously intervened at 150 yen against the dollar, but that did not appear to be an attempt to defend that particular level, rather it was to halt the pace of depreciation.
The yen at that time was weakening and there was a danger of it being viewed as a one-way bet weaker. There are huge institutional savings in Japan and many of these have been investing overseas in recent years. If this structural move continues then the yen may continue to weaken, despite the improving economic fundamentals in Japan.
Governor Ueda made clear that unconventional monetary policy was over and implied that future decisions would be data dependent, in line with other central banks. Although the BOJ gave no indication about future policy moves, its normalisation means rates will head higher – but gradually.
Please note, the value of your investments can go down as well as up.
