Is the Bank of Japan holstering its bazooka?

TOKYO — On December 20, the Bank of Japan (BoJ) decided to raise its ceiling on ten-year government bond yields from 0.25 per cent to 0.5 per cent. Within minutes of the announcement, the yen appreciated against the US dollar by 3 per cent, the Nikkei 225 fell by 2.5 per cent, and the ten-year bond rate jumped almost 25 basis points to approach the new ceiling.

This sharp reaction owed much to the fact that the decision took investors by surprise. The BoJ has long been intervening in the bond market to keep yields anchored close to the zero-bound, and the market was expecting it to maintain its current “yield curve control” (YCC) policy until the end of Governor Haruhiko Kuroda’s ten-year tenure in early April 2023. But, according to Kuroda, allowing more flexibility in the ten-year bond market has become necessary to reinforce the YCC’s effectiveness.

The BoJ had been purchasing increasingly large sums of ten-year bonds at the 0.25 per cent level, often adding them to its balance sheet a day after the Ministry of Finance issued them. Now, one can infer that the BoJ was alarmed to find itself purchasing bonds at an accelerating rate. After all, the yield curve recently dipped at the ten-year mark, meaning the ten-year bond rate was lower than both the nine-year and 15-year rates.

Although the YCC change is tantamount to a long-term interest-rate hike, Kuroda insists that it should not be interpreted as the first step in a broader process of monetary-policy tightening. The real interest rate, he notes, has been declining this year as the inflation rate has risen. By raising the cap on ten-year yields, the BoJ is effectively adjusting for inflation, not actually hiking the real interest rate.

Kuroda is correct on this technical point. But the tweak to the YCC could still be the first step toward monetary-policy normalisation. If so, it should be heralded as a sign that the BoJ has had some success with its decade-long ultra-easy monetary policy. Kuroda’s Bazooka, as it is colloquially known, may have hit its mark.

Since Kuroda’s appointment in 2013, the Japanese inflation rate mostly hovered above zero but far below 2 per cent, leading some critics to argue that the BoJ’s inflation-targeting framework was a failure. But others — including me — defended the framework. From the perspective of a flexible inflation-targeting regime, we argued, the BoJ was balancing below-target inflation with Japan’s strong GDP growth (or the unemployment rate) in its evaluation.

But one point was always clear: The BoJ had failed to anchor inflation expectations at 2%, which was supposed to be one of the great benefits of the inflation-targeting framework. Now, the inflation rate (excluding fresh food) has risen sharply. In January 2022, it was still at just 0.2 per cent; but it had reached 2.1 per cent by April, and 3 per cent by September. As in many other countries, this spike was driven by global energy- and food-price increases and a weakening currency.

Still, because Japanese inflation has been far below that of the United States (7.11 per cent), the United Kingdom (10.7 per cent) and the eurozone (10.1 per cent), the BoJ — until December 20 — has consistently refused to raise interest rates. As recently as October 2022, the members of its Policy Board projected that inflation would fall back to 1.6 per cent in 2023.

But there is now reason to suspect that this forecast will be proven wrong. First, just-released data for November show that the inflation rate, excluding energy and food prices, is at 2.8 per cent. Thus, even if energy and food prices stop rising in 2023, the inflation rate could remain above 2 per cent.

Second, next year’s “spring offensive” — annual pay negotiations — is expected to bring large wage hikes, partly to compensate for the higher inflation rate in 2022, and partly to redistribute the higher profits stemming from yen depreciation. In the event, substantial wage increases would replace some of the “cost push” inflation of 2022 with “demand pull” inflation (by increasing many households’ relative spending power), which tends to be relatively easier for consumers to accept.

That would be an ideal initial condition for the BoJ to start hitting its inflation target on a more sustainable basis. The New year may yet bring a happy ending to Japan’s decade-old ultra-easy monetary policy.

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 Poli.