BOJ’s New Governor Confronts Big Calls on Monetary Policy

While many advanced economy central banks are facing a dilemma over how to fight inflation in the middle of an outbreak of financial instability, the Bank of Japan (BOJ) is facing a unique dilemma of its own.

In 2022, Japanese inflation reached 4% — well above the BOJ’s target of 2%. Ten years since the BOJ began quantitative and qualitative easing to generate inflation, it is now seeing much higher inflation than it hoped for, the East Asia Forum wrote on April 3.

Yet it has refused to shift gears to normalize monetary policy. This has produced a sharp depreciation of the yen’s exchange rate. Although the deep dive in the yen was short-lived, its weakness since 2022 is one of the main drivers of inflation.

The weak yen has lifted import prices while nominal wages continue to stagnate. The return of inflation has given little cause for celebration as it eroded real incomes. The BOJ has argued that until a ‘virtuous cycle’ of price and wage increases occurs, its policy target cannot be achieved in a sustainable and stable manner.

This argument is misleading because the virtuous cycle won’t come by not changing monetary policy — quantitative and qualitative easing failed to generate price and wage growth for years.

Cost-Push Price Increases

Still, if the yen’s decline remains on pause, as it has since November 2022, cost-push price increases will eventually run their course, bringing inflation to a halt. So, high inflation of itself does not necessarily warrant a reversal of monetary policy.

But there are useful adjustments that the BOJ can make.

At the top of the list is yield curve control. This policy extends the BOJ’s tight control of interest rates at close to zero up to 10 years of maturity through purchase of Japanese government bonds.

Yield curve control worked fine while inflation was nowhere in sight and there was no pressure in the market to push up long-term interest rates. But when inflation surged globally in 2022, short sellers saw yield curve control as unsustainable and staged an attack on long-term Japanese government bonds.

Unnatural Kink

The BOJ has since ramped up its government bond purchases to push back the attack. But the distortions in the bond market are palpable — the yield curve (bond yields against time to maturity) has an unnatural kink at the 10-year mark as yields on longer dated bonds have risen higher.

As Haruhiko Kuroda exits, new BOJ governor Kazuo Ueda, who’s declared support for quantitative and qualitative easing, has singled out yield curve control as an area of potential change.

Yet there are three serious worries about the higher interest rates that will result from a relaxation or removal of yield curve control and the risk this policy shift might pose.

First, how badly will higher interest rates affect the economy? The BOJ may be tempted to keep prescribing a sedative of low cost money so that the patient continues to feel no pain.

But the prolonged reliance on sedatives may slow the patient’s recovery. Decades-long low interest rates in Japan have saved inefficient firms from failing but at the same time likely reduced the economy’s growth potential.

While allowing interest rates to rise is risky under precarious economic conditions, the estimated output gap in Japan, which widened during Covid-19, has now been closed. Now might be the time to test the patient’s resilience to a gradual reduction in heavy medication.

Second, what are the consequences of higher interest rates for financial institutions’ balance sheets and profitability? The BOJ’s biannual Financial System Report assesses the risk of a 100 basis point upward shift in the yield curve on financial institutions’ balance sheets being ‘close to the highest level since records began in fiscal [year] 2002’.

Magnitude of Risk

The magnitude of that risk relative to capital is ‘around 10% for major banks, around 20% for regional banks and around 30% for shinkin banks’.

If yield curve control is abandoned, 10-year Japanese government bond yields may rise by several hundred basis points, potentially occasioning serious financial instability. The BOJ needs to be well-prepared for this risk.

And third, the impact of changes to yield curve control on public finance could also be serious. Japan’s Ministry of Finance estimates that a 100 basis point upward shift in interest rates will gradually raise the government’s annual funding costs, reaching 3.6 trillion yen in the third year, or 15% of consumption tax revenue in 2023.

But raising tax or cutting major expenditure on things such as medical services and aged care to offset this loss is politically very difficult. Thus, the most likely outcome is a faster increase in public debt, which could trigger a fiscal crisis.

This is worrisome for Ueda, but it is the government, not the BOJ, which is ultimately responsible for averting a fiscal crisis. As the government noted in a 2013 joint statement with the BOJ, it needs to ‘steadily promote measures aimed at establishing a sustainable fiscal structure with a view to ensuring the credibility of fiscal management’. The longer you use sedatives, the harder it is to live without them.

Ueda’s task of yield curve policy reform and an eventual exit from quantitative and qualitative easing may be now more difficult because Kuroda didn’t bite the bullet sooner and do what is good for the long-term health of public finance and the economy. The dilemma that now confronts Japan’s central bank is one, in part at least, of its own making.