The Bank of Japan raised rates for the first time in 17 years

Insights for What’s Ahead

• The Bank of Japan ended its long-standing negative interest rate policy that was in place since 2016, establishing instead a new target range for the uncollateralized overnight rate of 0%-1%.
• The bank also officially ended its Yield Curve Control policy, but for the time being remained committed to “continue its JGB purchases with broadly the same amount as before.”
• Both policy measures reflected the fact that Japan’s inflation rate rose sharply through the course of 2022, peaking at 4.3% in January 2023. It has since slowed to 2.2%, but the bank’s policy statement expressed confidence that “the price stability target of 2% would be achieved in a sustainable and stable manner” by the end of 2025.
• However, we doubt that this is a sustained rate hike cycle because inflation is already close to the 2% target and the bank still “anticipates that accommodative financial conditions will be maintained for the time being.”

Background

In 2010, following the great financial market crisis, the Bank of Japan cut policy rates to 0%-0.10% and greatly expanded its Quantitative Easing program. By 2016, Japan was again facing deflation and a sharp appreciation of the Japanese yen that threatened to damage the economy’s export industries. In response, the Bank of Japan adopted a negative interest rate framework that applied a rate of -0.10% on reserve deposits accumulated from 2016 onwards. Reserves accumulated before 2016 still earned a positive rate of 0.10%.

This week’s announcement replaced the tiered interest rate system with a new 0%-0.1% target range for the uncollateralized overnight rate. It is essentially the system that existed between 2010 and 2016. The policy balance rate now represents the lower bound of the range, while a new 0.10% current account rate establishes the upper bound.

In addition to negative interest rates, the Bank of Japan also adopted Yield Curve Control in 2016, which aimed to extend interest-rate-targeting to the long end of the yield curve. The bank initially committed to purchasing Japanese government bonds (JGBs) in sufficient quantities to keep the yield on 10-year JGBs at 0%. In 2021, the bank allowed yields to fluctuate in a +/-0.25% range around the 0% target. That range was widened to +/-0.50% at the end of 2022, partly in response to the rise in global government bond yields.

Last year’s global inflation surge also impacted Japan and started to pull JGB yields higher. That would have forced the Bank of Japan to increase Quantitative Easing at a time when a reduction in monetary policy stimulus was needed to counter rising inflation. Hence, in July 2023, the bank announced the target was still 0% and the fluctuation range was still +/-0.50%, but it only offered to buy unlimited amounts of JGBs at 1%. Three months later, the bank eliminated intervention levels altogether. Essentially, the 0% 10-year bond yield target became irrelevant.

The trigger for the significant change in the Bank of Japan’s monetary policy framework was evidence of a strong increase in Japanese wage growth last year. Government data showed average annual wages grew at a rate of 3.6% in 2023, the fastest rate in 30 years. That pace is not likely to be sustained in the coming years. But the Bank of Japan has gained enough confidence that the economy will grow at a robust enough pace to prevent inflation from falling back to the zero bound.

Forecast Implications

Ending the Yield Curve Control is unlikely to result in a dramatic increase in Japanese bond yields. That should be ensured by the Bank of Japan’s continued commitment to intervene in the JGB market if yields increase too fast or reach levels the bank regards as incompatible with achieving and maintaining inflation at 2%. Similarly, raising policy rates from just below 0% to just above 0% can in no way be described as monetary policy tightening. However, announcement did restore credibility in the Bank of Japan’s monetary policy strategy. Negative policy rates looked greatly out of line with Japan’s own macro fundamentals and monetary policy trends in the rest of the world. Moreover, the bank had largely abandoned Yield Curve Control well before the announcement.

Consequently, we do not see the need to change our real GDP growth forecasts for Japan. After barely skirting a recession in the second half of 2023, we still forecast an improving quarterly real GDP growth trajectory this year. Based on the uptick in consumer confidence at the turn of the year, last year’s strong wage growth, and the announcement of a significant fiscal stimulus program. Our 2024 annual growth forecast of 1% is heavily impacted by the weak finish to 2023. A better comparison is the forecasted average of the quarterly growth rates in 2024 of 2%, which represents an increase from last year’s 1.3% average.