Japan holds a staggering amount of debt, with over $1 trillion invested in U.S. government treasuries alone, making it the most indebted country in the world. The impact of even the slightest adjustment to Japan’s low interest rates extends far beyond its borders, potentially driving up rates globally.
Therefore, when the Bank of Japan recently announced a slight loosening of its control on benchmark government bonds, it caused a major stir in world markets. This move suggests that Japan is considering revising its longstanding commitment to cheap money, which was implemented to stimulate the country’s sluggish economic growth. Rising interest rates abroad have led to increased inflation and a weakened yen, prompting Japan to explore new approaches.
In a statement after a two-day policy meeting, the bank expressed a desire to adopt a more flexible approach to controlling yields on 10-year government bonds. This effectively means they will allow the yields to exceed the current ceiling of 0.5 percent. The bank’s intention is to “enhance the sustainability of monetary easing” and adjust to both upside and downside risks to Japan’s economic activity and prices.
This decision comes after months of speculation regarding the possibility of the bank tightening lending. The ultra-easy monetary policy implemented by the bank aims to achieve demand-driven, sustainable inflation of 2 percent, a level that policymakers believe would uplift corporate profits and wages in a virtuous cycle. Inflation in Japan, the world’s third-largest economy, has exceeded this target for over a year, reaching 3.3 percent in June. However, the bank’s governor, Kazuo Ueda, has expressed doubts about the sustainability of these price increases, mainly attributing them to supply-side issues. Consequently, analysts do not anticipate a policy adjustment until later this year.
The bank revised its forecast, anticipating inflation to reach 2.5 percent in fiscal year 2023, a significant increase from its previous estimate of 1.8 percent. The primary factor behind this adjustment was cited as “cost increases led by the past rise in import prices.”
Controlling bond yields has been a fundamental aspect of Japan’s monetary easing policies. The 10-year bond plays a crucial role in determining Japanese lending rates, which policymakers have sought to keep at rock bottom to stimulate economic growth by making money more affordable for borrowers.
However, this effort has come at a considerable cost, as the bank has had to spend massive sums purchasing its own bonds to keep yields low. In recent times, the Bank of Japan has faced mounting pressure as other central banks, led by the Federal Reserve, have begun raising rates to tackle inflation resulting from the pandemic and geopolitical events such as Russia’s invasion of Ukraine.
While inflation in Japan has not reached levels seen in the United States and Europe, rising interest rates abroad have severely weakened the yen. Money has flowed out of the country in search of higher returns, exacerbating inflation in Japan, a nation heavily reliant on exports for food and energy.
Nevertheless, the Bank of Japan has remained steadfast, resisting domestic calls for intervention and speculators betting against Japan’s ability to defend its yield target. The recent announcement is likely to test the bank’s dedication to the new trading band, potentially leading to further adjustments or even a complete abandonment of the policy.
However, unwinding Japan’s monetary easing measures is neither a quick nor easy task. Years of low rates mean that even small increases in interest rates could have significant consequences for households and businesses, which have become reliant on easy access to low-cost loans.
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