In Japan, inflation is on the rise. As a result, and with a relatively new Bank of Japan (BoJ) governor, Kazuo Ueda, in office, many are asking whether a shift in monetary policy is imminent. We are watching closely as any moves could be a game changer for domestic and global markets.
Traditionally, Japanese monetary policy implements yield curve control (YCC), whereby the central bank keeps short-term interest rates below 0% and long-term rates below 1%. As a result of global rate increases over the course of 2022, investors initially feared that Ueda would immediately bring an end to this policy. However, his inaugural meeting saw him commit to conducting a long-term evaluation of the policy, leaving these initial concerns parked for now.
Politically, this a convenient move. But there is a precedent for central bankers adjusting their policies in the interim, or as economist John Maynard Keynes once put it, “when the facts change, I change my mind”. This has already happened in Japan when Ueda’s predecessor, Haruhiko Kuroda, committed to easing and not changing policy, until he shocked the market in December 2022 by raising the upper bound for YCC. On 28 July, Ueda himself pivoted by again adjusting the YCC upper bound in a flexible way and continuing along the path towards normalisation.
Land of the rising interest rates
Yet there is a significant reason for the BoJ to now start changing its policy: inflation. It is finally rising and core inflation (Nationwide, ex-Fresh Food & Energy, June 2023) now stands at 4.3%. While this pales in comparison to UK inflation rates, for example, these are levels not seen in Japan since the early 1990s when the Japanese economy was overheating. Thirty years later, given current tightness in the labour market, wages in Japan are starting to rise; the question now therefore is not whether policy will be adjusted, but when.
In reaction to this, bond yields will start to rise rapidly. This will be a shock, particularly to the Bank of Japan itself which has ¥580trn in government bonds (around $4trn) on its balance sheet. As interest rates rise, these bonds are set to fall in value considerably. Japan has extremely elevated public debt levels at 262% of the total economy; higher interest rates would put a severe strain on the sustainability of that debt and put a significant dent in the government budget.
Global impact and a tsunami of Yen
Higher interest rates would admittedly make the Japanese Yen more attractive to foreign investors, as well as support the exchange rate. It will also cause Japanese investors to repatriate their money as these rates become relatively more attractive. However, higher rates would also negatively impact Japanese exporters as they would become less competitive on the global stage, likely driving a negative relationship between the Yen and Japanese equity prices.
Currently, Japanese investors represent the largest foreign footprint in US Treasuries, and therefore if Japanese investors start to sell their foreign bond holdings, global bond markets could suffer greatly. As recently as December 2022, the impact of the BoJ’s policy change was particularly acute in countries such as Australia, where bond yields rose an astonishing 70bp through the month as the BoJ and other central banks delivered a hawkish surprise.
The shock of Japanese policy normalisation will therefore likely trigger a tsunami of Yen. That wave of money will ripple across global markets as the last major developed market central bank moves away from extremely easy monetary policy. While gradualism appears to be working for now, as the BoJ takes its time in considering all the implications of changing course, it may find its hand is forced by surprisingly resilient inflation and risks from changing policy will continue to build.
Japan’s economy has finally broken out of persistently weak inflation and the monetary policy easing experiment, defined by Governor Kuroda, has been effective. We hope that Governor Ueda’s normalisation of policy will be just as successful in the months to come.
Corne van Zeijl is strategist and economist and David Goldberg is strategist at Cardano.
This story first appeared on our sister publication, Portfolio Adviser.