While the challenge of low inflation might seem contrary to the current plight of many developed economies (and counter-intuitive given the effect inflation can have on consumers’ standard of living), it is a significant issue given Japan’s huge debt burden. According to the International Monetary Fund (IMF), Japan has the highest debt level of any nation, coming in at more than 260% of gross domestic product (GDP).

In an effort to stimulate greater economic growth and induce higher inflation (and thus reduce the value of this huge debt pile), the BOJ undertook some of the most unconventional monetary policy throughout the world. This included setting its benchmark interest rate to a negative number, a previously unheard of move that was subsequently adopted by other central banks, such as the European Central Bank (ECB).

Yet, unlike the ECB, the BOJ has been slow to return benchmark interest rates to a “normal” positive number. Japan did not suffer a surge in inflation during the past couple of years to the same degree as Europe, the U.K., U.S. or even Australia, and the BOJ has only recently become comfortable that inflation was sustainably above its target of 2%–despite it exceeding this number for about a year.

The BOJ announced on Tuesday that it had set the new short-term interest rate at between 0% to 0.1%. This is unlikely to have a material impact on borrowing costs for either consumers or businesses in Japan, but the first rate hike in 17 years is more seen as a strong signal that the nation is finally leaving behind a long period of economic stagnation and low inflation.

The BOJ also declared that the short-term interest rate will now be its main policy tool, implying that it is set to abandon other less conventional measures such as purchases of exchange-traded funds (ETFs) and yield curve control (YCC). Introduced in 2016, YCC involves the central bank setting targets for interest rates for a range of durations along the yield curve and purchasing as many Japanese Government Bonds (JGBs) to reduce each respective interest rate to the desired level.

As a quick refresher, the yield curve is a line (plot or curve) showing the interest rates (or yields) of bonds with different durations or maturity dates. The most commonly cited of these would be the U.S. government par yield curve, which shows the current interest rates for U.S. government bonds ranging between 1 month and 30 years. More specifically, it tells us the interest rate an investor receives if they purchased a U.S. government bond maturing in one month or 30 years today.

Typically, the yield curve slopes up and to the right, with higher interest rates for bonds with longer durations (this is because it is generally riskier to lend someone money for a longer period of time, as they are less likely to repay you). The cost of interest-rate-sensitive products, such as business loans, car loans and mortgages, are based on different parts of the yield curve. This creates a challenge for central banks.
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In conventional monetary policy (that is, how it used to be), central banks are only able to change the short-term interest rate (the interest rate used for borrowing money for say 1 month). Essentially, the central bank hopes that if it changes this short-term rate, it will also cause changes to the rest of the yield curve, reducing the interest rates for longer durations. These lower interest rates will encourage consumers to buy more cars and houses, and businesses to take on more loans to expand their production and services. Unfortunately, this doesn’t always work.

The BOJ employs unconventional monetary policies like YCC to manage interest rates along the yield curve. Here, the BOJ expands the supply of money and uses these additional funds to purchase bonds of different durations to achieve the desired interest rates at each point along the yield curve. Buying lots of government bonds of a particular duration can directly lower the yield (aka interest rate) at that point on the yield curve. For example, buying 30-year government bonds can lower the interest rate on the 30-year yield, which might allow consumers to access a cheaper mortgage rate (since many mortgage rates are for 30 years). This can encourage more people to buy new houses, which can stimulate the construction industry and the economy at large. This is essentially the same process as what is known as quantitative easing (QE), which Australia and many other countries undertook during the pandemic.
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As part of the BOJ announcement, Governor Kazuo Uedo announced that Japan was finally scrapping its yield curve control program but would continue to buy some long-term government bonds as needed to keep interest rates “accommodative.” Essentially, the BOJ will no longer be on a buying spree to keep interest rates along the yield curve at specific levels but will continue to keep yields artificially low to stimulate demand. It is expected to maintain this strategy until underlying price trends show that inflation expectations for the future reach 2%, which Ueda said was “still some distance.”

Seeing the cost of living pressure across Australia, the U.K., Europe and the U.S., it can seem like a foreign concept to see a government actually trying to increase inflation. But while inflation is currently a dirty word in many parts of the world, it can also come along with economic growth and higher wages for workers. These are two things that Japan has struggled with since the GFC, and in part even longer, due to the enormous economic boom and bust that we described in our first article on Japan and the nation’s demographic and labour force challenges that we described in our last article.
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Yet wage growth appears to be improving, with the labour unions requesting a whopping 5.85% average wage rise, the largest since 1993 according to the Japanese Trade Union Confederation (aka “Rengo”), Japan’s largest trade union. Any continuation in this type of wage growth would undoubtedly boost the overall inflation numbers, and could lead to further changes to the BOJ’s monetary policy. After all, benchmark interest rates have only just hit positive territory and the BOJ continues to buy government bonds, both measures that were wound back some time ago in the rest of the world.