Most analysts agree that Japan’s central bank will eventually abandon its ultra-loose monetary policy, and that the turning point could pose a significant threat to the stability of the global financial system. The only questions are when it happens and whether it can take place in a manner that causes as little disruption as possible.
Why Japan’s monetary policy means so much for global financial markets
Forewarned is forearmed?
Investors can’t say they haven’t been warned about the potential consequences if the Bank of Japan (BoJ) finally changes its monetary policy. The International Monetary Fund (IMF) said in May that a shift from ultra-low interest rates could have a significant impact on global financial markets. 1
Moreover, back in December 2022, investors saw concrete evidence of the possible effects. Global bonds and equities sold off sharply following the BoJ’s surprise decision to loosen its yield-curve control (YCC) policy. 2 YCC was introduced in 2016 with the aim of keeping yields very low across longer-dated maturities to encourage consumers to spend and businesses to invest, and to head off deflation. The markets interpreted the December change as a signal that the central bank would pivot towards tightening monetary policy.
It’s easy to see why pressure is growing on the BoJ to change direction. After decades of deflation, inflation is finally taking hold in the country. Core inflation reached 3.1% in August, thus remaining above the BoJ’s 2% target for the 17th consecutive month. At the same time, central banks around the world have spent much of the past two years hiking interest rates significantly to counter inflationary pressures. The growing interest-rate differential between Japan and the rest of the world has put downward pressure on the yen and further fuelled inflation.
Rising interest-rate differential increases pressure to end ultra-loose monetary policy
The reason why all this matters to global markets is that Japanese investors have spent more than $3 trillion offshore in search of higher yields. 3 The Japanese are the biggest foreign holders of US government debt, and according to Bloomberg, Japanese funds ‘have massive investments in everything from Brazilian sovereign debt to European power stations and high-risk loans’. 4 The danger is that policy normalisation could prompt the Japanese to withdraw this money and reinvest it back home.
The reversal in flows is already underway, says Bloomberg. Japanese investors sold a record amount of overseas debt last year as local yields rose on speculation that the BoJ would normalise policy. 5 The worry is that the trickle of funds returning to Japan could turn into a tsunami, with devasting consequences for borrowing costs in economies such as Australia, where bond yields rose by a staggering 70 basis points during the YCC tremor in December 2022. 6 Estimates suggest the Japanese own up to 15% of Australia’s sovereign and semi-sovereign bonds, leaving Australia highly exposed. By contrast, Japanese investors own about 5% of US Treasuries. 7
Against this background, all eyes are on BoJ governor Kazuo Ueda, who took the helm of the central bank in early 2023. He has the unenviable task of anchoring global investor perceptions of where Japan’s policy is headed, while maintaining domestic monetary stability. And investors are ‘poring over his every word for any hint on when he might start unwinding the country’s ultra-loose monetary policy’, according to the Financial Times. 8 To date, Ueda has been successful with this balancing act. In July, for example, the central bank loosened the YCC again without the disruption in financial markets that took place in December, when Ueda’s predecessor was still in charge.
The focus now is on when the central bank is likely to lift the base rate from -0.1%, where it has been since 2016.
9 Ueda has said wage growth is key to determining whether inflation has taken a sustainable grip on the economy. He has also expressed concern about weakness in inflation-adjusted wages. 10 Real wages fell for the 17th consecutive month in August. 11
Despite Ueda’s caution, the majority of analysts polled by Reuters in September said they expected the BoJ to end negative rates next year, and most also see YCC ending this year. The question is whether the policy exit can be conducted in an orderly manner, given that a disorderly one could have dramatic consequences for financial markets and the global economy.
2 https://www.reuters.com/markets/asia/view-bank-japan-reviews-yield-curve-control-policy-2022-12-20/
7 https://www.nasdaq.com/articles/australian-bonds-face-squeeze-as-japans-cash-returns-home
8 https://www.ft.com/content/7e1100b6-b4a5-468d-a75c-3f153bad0bc1
11 https://www.reuters.com/markets/asia/japanese-real-wages-decline-august-17th-month-2023-10-05/
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