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The Bank of Japan (BoJ) caught global financial markets off guard in December with its decision to ease the long-term bond lending corridor and expand it to minus 0.5% to plus 0.5%. Until then, the BoJ was the only major central bank, which stuck to the now outdated decades-long zero interest rate era, but with the expansion of the yield corridor, it is doing a U-turn. What does this mean for future policies? A guest commentary by Modupe Adegbembo, G7 Economist at AXA Investment Managers.
Many investors are now speculating over tighter monetary policy by the Bank of Japan. This follows the decision to allow a stronger increase in interest rates for long-dated government bonds in the future. Some fear that the BoJ may now initiate a tightening cycle, as we have seen in the US and Europe. But there are good reasons for believing things will be different in Japan – because unlike in the US and Europe, domestic inflationary pressures remain subdued.
The rise in inflation so far has been almost entirely due to rising energy prices, a weak yen and supply chain bottlenecks affecting imported products. The widening of the yield corridor allowed the yen to appreciate immediately by several percentage points. For this reason, beyond inflation, the BoJ emphasises that wage growth is a necessary condition for changing its ultra-accommodative policy stance.
Fewer monetary policy incentives
This philosophy was maintained under the government of Haruhiko Kuroda. However, it could change with the appointment of a new BoJ governor in April 2023. Deputy Governor Masayoshi Amamiya and former Deputy Governor Hiroshi Nakaso are seen as top candidates. Nakaso is widely seen as a proponent of reducing monetary stimulus. His appointment would increase the risk of a policy change starting in the third quarter of 2023 after the spring wage negotiations.
At present, we still do not expect the inflation target of 2% to be achieved in the next two years. Now, the BoJ has decided to reduce its support as it expects a gradual increase in domestic price pressures and higher wage settlements in the upcoming spring wage negotiations. This action may reflect the BoJ’s assessment that the Japanese economy no longer needs as much monetary stimulus.
The fact that the Bank of Japan adjusted its policy at the end of the year could be taken as an indication that it expects improved external conditions in spring 2023. However, in the event of weaker global economic conditions, the BoJ could proceed more cautiously and wait to see how inflationary pressures develop and whether core inflation remains above the previous level after the energy shock has subsided.
Impact on the economy
A radical turnaround in interest rates could have serious consequences for the Japanese economy. This is because it has been characterised by low interest rates for such a long period that even a small increase in interest rates could have a significant impact.
Households have accumulated considerable debt at floating rates due to low interest rates, so they are at risk if interest rates rise. Even small interest rate moves could severely curb demand. Between 2014 and 2022, the share of adjustable-rate mortgages increased from 39.3% to 73.9%. A change in borrowing rates would quickly impact the real economy and increase the cost of servicing debt for most households. This would put further strain on domestic consumption, which is already strained by rising prices.
In addition, an interest rate hike could expose the Japanese government to risks regarding the sustainability of its public debt. Japan’s public debt stood at 262.5% of gross domestic product (GDP) in 2021 – the highest of all G7 economies.
The debt level is expected to rise further as the government has supported businesses and households with substantial tax breaks. This was intended to cushion the economic damage from rising energy prices and inflation. Low interest rates have allowed Japan to accumulate this debt.
Furthermore, sharply rising interest rates could jeopardise Japan’s recovery from the pandemic. Economic growth has only just recovered to pre-pandemic levels. We expect Japan to continue above-trend growth this year and next if the recovery continues. An overly hawkish approach by the Bank of Japan, as well as higher borrowing costs in the economy, could put the brakes on this fragile recovery. This underscores why we expect the BoJ to remain cautious in adjusting its policy.
Modupe Adegbembo
G7 Economist
AXA Investment Managers
Modupe Adegbembo is G7 Economist at AXA Investment Managers. She joined AXA IM in 2021 from the UK Department for International Trade, where she worked as an Economic Adviser and previously Assistant Economist since 2017. She has a Bachelor’s and Master’s Degree in Economics from University of Warwick and University College London.
