No country in the world holds as much debt as Japan, which has well over $1 trillion in U.S. government treasuries alone. Even the slightest shift to Japan’s low interest rates reverberates well beyond its borders, with the potential to drive up rates globally.
So, when the Bank of Japan on Friday loosened its grip on a benchmark government bond, it was big news for investors around the world.
The move was the latest signal that the country may revise its longstanding commitment to cheap money, meant to spur Japan’s sluggish economic growth, as rising interest rates abroad have driven up inflation and weakened the yen.
In an announcement that came after a two-day policy meeting, the bank said it would take a more flexible approach to controlling yields on 10-year government bonds, effectively allowing them to slip above the current ceiling of 0.5 percent.
The change comes after months of speculation that the bank could move to tighten lending, following a decision last December to double the 10-year bond’s trading range to plus or minus 0.5 percent.
That change led to a speculative assault on the new yield target, forcing the Bank of Japan to spend big in an effort to hold the line.
Lessons learned from that experience probably informed the bank’s new approach, according to Stefan Angrick, a senior economist at Moody’s Analytics in Japan.
“The December tweak kind of blew up on them,” he said. Rather than taking pressure off the bank, the policymakers “had to come into the market and push back even harder.”
The most likely outcome of Friday’s change is that the bank will “gradually reduce” its bond purchases while letting rates rise incrementally, Ayako Fujita, Japan chief economist at J.P. Morgan, wrote in an analyst’s note.
In an analyst note, Naohiko Baba, chief Japan economist at Goldman Sachs, described Friday’s move as “effectively akin to a rate hike.” But, he added, officials packaged it in a novel form because they “did not want the market to interpret it as the start of full-blown tightening.”
In its statement, the Bank of Japan said it would offer to buy 10-year bonds at twice the previous rate, a move that many analysts saw as a stealth attempt to allow bonds to trade at significantly higher yields.
The bank’s ultra-easy monetary policy is aimed at attaining an inflation rate of 2 percent over time, driven by consumer and business demand, a level policymakers believe would lift both corporate profits and wages in a virtuous cycle.
Inflation in Japan has exceeded that target for more than a year, hitting 3.3 percent in June. But the bank’s governor, Kazuo Ueda, has questioned whether the price increases — which have been largely attributed to shortages of certain goods — will last, leading most analysts to expect that a policy tweak would not happen until later this year.
In a statement, the bank said that it expected that inflation would reach around 2.5 percent in fiscal year 2023, an increase from its previous forecast of 1.8. It cited “cost increases led by the past rise in import prices” as the main factor in the change.
In the longer term, however, it expects inflation will drop below the 2 percent target in 2025.
Controlling bond yields has been one of the central elements of Japan’s monetary easing policies.
The 10-year bond plays a key role in setting Japanese lending rates, which policymakers have sought to keep at rock bottom as part of their efforts to stimulate economic growth by making money cheaper for borrowers.
The effort has come at a high cost: to keep yields down, the bank has had to spend enormous sums on purchasing its own bonds. After the Bank of Japan loosened the trading range last December, it spent the equivalent of over 3 percent of the country’s gross domestic product buying more bonds to rein in the market.
The Bank of Japan has come under increasing pressure over the last year as other central banks, led by the Federal Reserve, began raising rates in an effort to battle inflation stemming from the pandemic and Russia’s invasion of Ukraine. On Wednesday, the Fed raised interest rates a quarter point to 5.5 percent, their highest level in 22 years.
Inflation in Japan never reached the heights seen in the United States and Europe. But rising interest rates abroad substantially weakened the yen, as money flowed out of the country in search of higher returns. That worsened inflation in Japan, which is highly dependent on exports for food and energy.
Nonetheless, the bank stood firm, resisting both domestic calls to intervene and assaults by speculators hoping to profit by betting against Japan’s ability to defend its yield target.
Friday’s move is likely to put more pressure on the bank as markets seek to test its commitment to the new approach, potentially leading to further loosening or even a complete abandonment of the policy.
But unwinding Japan’s easy money policy will not be quick or easy. Years of low rates mean that even small interest rate increases could be costly for households and businesses, which have come to rely on easy access to low-cost loans.