The big test is yet to come for the BoJ

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Apathy and anticlimax are what a central bank aspires to when the time comes for a momentous policy decision. By this measure, the Bank of Japan’s return to positive interest rates was a triumph — with high rates elsewhere, and governor Kazuo Ueda taking a year to reach this well-flagged decision, his 0.1 percentage point rise in Japanese interest rates sent no shockwaves. The yen barely twitched. It is still close to the ¥150 lows against the dollar it found when US rates began to climb in 2022.

So does this mean Japanese monetary policy, which for a generation has led the world into exotic innovations such as zero interest rates, quantitative easing and yield curve control, will be boring from now on? Perhaps for a little while, but a little while only. All of Japan’s big structural challenges — ageing, population decline, sluggish consumption, high public debt and low economic growth rates — remain the same. As a result, it is not clear if there is any stable equilibrium where Japan chugs along with consistently positive interest rates and inflation at its 2 per cent target. The BoJ has signed an armistice with unconventional monetary policy, not a peace treaty.

In its decision, the central bank proudly notes the prospect “that the price stability target of 2 per cent would be achieved in a sustainable and stable manner”. But it recognises that this success is precarious and may not endure.

“There are extremely high uncertainties surrounding Japan’s economic activity and prices,” the BoJ says. That description of “extremely high uncertainties” translates, in central bank vernacular, to “pretty much anything could happen”.

“Given the current outlook for economic activity and prices, it anticipates that accommodative financial conditions will be maintained for the time being,” Japan’s central bank says. It is less a declaration of mission accomplished than a positive report on progress.

Japan is about to confront the so-called 2025 problem. Long anticipated, this is the moment when the last of the post-second world war baby boom generation would reach 75, the first of them would become 80, and both their mortality and need for healthcare would start to accelerate. The most acute phase of Japan’s population decline will take place over the next 20 years before its demography stabilises somewhat in mid-century. With this as the backdrop, there is almost no prospect of real growth in Japan’s economy; the desire to save is high and the desire to invest is low; hence, the underlying real interest rate is probably around zero.

Add the inflation target on to an underlying real interest rate of zero and it appears that the average BoJ interest rate, over the economic cycle, might average about 2 per cent. But even this will be hard to achieve consistently. While headline wages at big companies are set to rise strongly this year, there is little sign of broad-based wage growth across the economy, or any appetite for greater consumption. Where spending does rise, much of it goes on medicine and care at regulated prices, with increased demand leading to rationing rather than inflation. Furthermore, even interest rates of 2 per cent would leave little room for cuts in bad times. Whenever there is a shock, the BoJ is likely to find itself back at zero again.

Policy normalisation makes sense as a signal of confidence by the BoJ. A 0.1 percentage point rise in borrowing costs will not have much impact by itself, and at this stage, a return to positive rates offers some encouragement to households and companies. It is unlikely, however, to mark the start of a sustained shift towards higher interest rates in Japan.

Rather than the BoJ’s move, the big test for Japan will come when the US Federal Reserve starts to lower interest rates, most especially if there is a big enough slowdown for the Fed to cut sharply. Since the BoJ is unlikely to raise rates much, action on the other side of the Pacific is more likely to narrow the yawning gulf in yields between US Treasuries and Japanese government bonds.

That, in turn, would probably cause appreciation in the yen, leading to a reversal of the external pressures that have raised inflation in Japan over the past few years — at which point the country would have to rely on domestic wages and consumption to keep prices rising. It is that moment, not the return to positive interest rates, that will mark the true test of whether, almost 30 years after losing it during the so-called lost decade, the BoJ has regained control over the price level.


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