The combination of rising inflation and decent growth will likely push the Bank of Japan toward policy normalization this year. But what are the implications of this tectonic shift?
In 2013, the Bank of Japan (BoJ) issued a historical joint statement with the government of Japan to set the year-on-year consumer price index stability target at 2%. To achieve this objective while supporting growth, the BoJ famously deployed extraordinary monetary policies, including targeting short-term interest rates at -0.1% and aiming to maintain the 10-year Japanese Government Bond (JGB) yield at 0%. A yield curve control (YCC) policy was subsequently introduced, restricting the band within which the yield could fluctuate. This was originally set at ±10 bps, raised to ±20 bps in September 2018 and subsequently to ±25 bps in May 2021.
Despite these tweaks and despite lagging the global surge, Japanese inflation has been trending higher since 2022 and recently rose over the 2% target. Partly as a result, the BoJ surprised markets in December by further amending the YCC policy to target 0%±50 bps, which fueled immediate speculation of additional widening. The central bank dashed these hopes at the January meeting when it left policy unchanged even as it raised FY 2024 inflation forecasts by 20 bps to 1.8%.
Nonetheless, in our view, the YCC framework has reached its limit as the BoJ simply cannot keep buying bonds due to its extreme market footprint. For example, in January 2023, the BoJ purchased a record ¥23.7 trillion worth of bonds, the highest on record. In some extreme cases, it ended up holding more than 100% of the issuance of certain bonds. This idiosyncrasy results when the BoJ purchases the entire stock of available bonds and then lends them to short sellers, who subsequently sell them back to the central bank (Figure 1).
Figure 1: BoJ’s Share of 10-Year JGB Issuance
In our view Japan's central bank is preparing for a more typical policy environment, in part because of this reason as well as other factors that we expand on in the section below.
Our sanguine view on policy normalization is burnished by Japan’s improving macroeconomic conditions.
Firstly, we expect current inflation to be broad based despite electricity subsidies and the base effect of food prices. Although we expect some volatility in prices, inflation is likely to be higher than its long-run averages.
Secondly, growth prospects look reasonably good. The BoJ estimated the negative output gap to be near zero in the third quarter, and the economy may well grow above potential this year. In fact, based on our forecasts, Japan is only one of two major economies (China is the other) that is expected to grow faster in 2023 than in 2022.
And finally, the tight labor market (the unemployment rate was just 2.5% in December) offers a conducive environment for a pickup in wages. The “shunto” wage negotiations that happen in March, between unions and employers, may likely yield about 3% growth, including seniority pay. Besides, the current inflation levels are likely to exert upward pressure on wage revisions.
We expect the BoJ to modify the YCC policy again this year to target 0%±100 bps or 0.5%±50 bps, allowing the 10-year JGB yield to trade between 0.5% and 1.0%. Markets have already priced this in with the 10-year swap rates trading near 1%. Given the BoJ’s ability for surprises, it may also consider other options.
The BoJ may raise interest rates and exit its negative interest rate policy (NIRP) in 2024. But we do not expect any aggressive changes for the following two reasons: an uncertain global outlook and 20% of outstanding JGBs being scheduled to mature this year.
Japanese investors have been net sellers of global bonds in 2022 and the trend should continue in pursuit of higher domestic yields. Although overseas investors’ interest in JGBs has been low, the long-term trend has been upward – overseas investors hold 14.1% as of Q3 2022 versus 5.7% in Q1 2010.
These trends should ease some pressure on Japanese yields and add some upside risk to global yields, especially US yields. Indeed, starting November 2021, Japanese holdings of US Treasuries have been declining, falling by US$246.4 billion by November 2022. This compares with the reduction of US$346.5 billion in US Treasury securities held outright by the US Federal Reserve (Figure 2).
Figure 2: BoJ’s Policy Normalization Has Implications for Global Yields
The impact on the domestic economy may be felt through two main channels: home loans and corporate debt, both of which will be more affected by NIRP than YCC amendments.
About 74% mortgages in Japan have a floating rate and since rising 10-year yields have an impact only on new fixed-rate loans, their effect is limited. However, the market will be affected if the benchmark of floating loans – the short-term prime rate – is raised by the BoJ.
Similarly, corporates (ex. financial companies) have nearly 50% of their debt borrowed as long-term loans and the long-term prime rate – the benchmark (adopted by Mizuho Bank) for blue-chip companies – rose by 40 bps from 1.0% last year (Figure 3).
Figure 3: Structure of Japan’s Benchmark Rates
Given the reasons elaborated above, the possibility of the BoJ normalizing monetary policy is no longer a mirage. We expect the BoJ to modify its YCC policy this year, and if the Japanese and global economies were to avoid a recession, exiting NIRP is a real possibility come 2024.
A global recession is the biggest risk to our views. We cannot rule out deterioration in the Japanese macroeconomy as consumption has shown historical weakness when inflation hits the 2% level. Risks from outside of Japan are, however, more substantial than those from within Japan.