Japan’s monetary policy peculiarity

Author: Sayuri Shirai, Keio University

The Bank of Japan’s (BOJ) monetary policy framework has been characterised by yield curve control since 2016. That involves the stabilisation of the 10-year government bond yield — the cost of borrowing for the Japanese government — at around zero per cent and a so-called negative interest rate policy in which -0.1 per cent interest is charged on a small portion of excess reserves.

Massive quantitative easing is no longer the main element of the BOJ’s monetary policy, with the exception of expanding its balance sheet to cope with the pandemic-induced recession in 2020–2021. Many of its monetary accommodation tools, including most lending operations to commercial banks, treasury bills, stock exchange traded funds and corporate bonds, were terminated or are now undertaken infrequently — shrinking the BOJ’s balance sheet.

The BOJ introduced flexibility into their 10-year bond yield target by introducing plus or minus 0.2 per cent of leeway in July 2018. This flexibility was enhanced in March 2021 when the BOJ announced it would allow the 10-year yield to deviate from zero by up to 0.25 per cent. In the face of global monetary tightening led by the Federal Reserve, Japan’s current inflation performance gives the BOJ reason to expand the target range further.

Inflation has been over the central bank’s 2 per cent price stability target since April 2022, reaching three per cent in August 2022. But the BOJ appears determined to maintain the status quo. BOJ Governor Haruhiko Kuroda emphasised that the high inflation rate was mainly due to global commodity prices, not a favourable increase in domestic demand.

The BOJ is more reluctant to increase flexibility than it has been in the past. It might be worried about a repeat of June 2022 when foreign hedge funds shorted Japan’s sovereign bonds in spot and futures markets. They attempted to raise the 10-year yield above 0.25 per cent, anticipating that the BOJ would abandon their 0.25 per cent ceiling and raise the yield if the yen depreciated significantly.

The yen has been excessively undervalued in 2022 because of the widening gap in 10-year yields between the United States and Japan. The BOJ defended its ceiling by purchasing over 16 trillion yen worth of bonds (US$114 billion) in June 2022.

This defensive action may reflect the BOJ’s assessment that it is better to maintain the status quo and avoid inviting a new round of speculative activity. Another round of short selling might force the BOJ to adopt even higher ceilings. The concern is that, like in Australia and South Korea, an increase in the policy rate rises in line with the United States, which will also raise the 10-year yields among the three countries, is unlikely to stop the yen’s undervaluation.

In contrast to Japan, inflation in South Korea is much higher and has already exceeded the central bank’s 2 per cent medium-term target set in 2021. The inflation rate was 5.7 per cent in August 2022 despite a moderate decline from 6.3 per cent the previous month.

The Bank of Korea (BOK) initiated a policy rate hike from 0.5 per cent to 0.75 per cent in August 2021 and has since raised rates six times to 2.5 per cent. The BOK’s monetary policy stance reflects the need to contain high inflation and avoid any further depreciation of the South Korean won against the US dollar.

The BOK Governor made an interesting remark in August 2022 that the central bank was independent of the government — but not from the Federal Reserve. South Korea’s policy rate will need to be raised further if the Fed continues to hike. To preserve the currency, any rate hike undertaken by the BOK cannot end before the Federal Reserve stops increasing rates. Rhee also stated that the BOK will continue to normalise interest rates as long as inflation remains around 4–5 per cent.

Like South Korea, the Reserve Bank of Australia (RBA) initiated a rate hike in May 2022. Its first hike since 2010, the RBA increased the rates from 0.1 to 0.3 per cent. It has since raised the policy rate four times, reaching 2.35 per cent in August 2022. While the RBA was slow to raise its policy rate despite inflation exceeding its 2–3 per cent target range in June 2021, the pace of the rate hike was much faster than the BOK.

Like South Korea, the Australian dollar has depreciated against the US dollar. Australia’s 6.1 per cent inflation rate in the 2022 April–June quarter reflected supply-side factors, strong domestic demand and a tight labour market, like the United States.

These two central banks are likely to raise their policy rates again soon as high inflation is expected. On 21 September, the Federal Reserve raised the federal funds rate by 75 basis points to 3-3.25 per cent .

The BOJ is taking a different approach from the BOK and the RBA even though the yen is excessively undervalued. Japan, South Korea and Australia are experiencing exchange rate depreciation against the US dollar and higher inflation through imported prices. Raising policy rates has not stopped exchange rate depreciation in South Korea and Australia, so the BOJ’s maintenance of the status quo can be justified as long as inflation remains at around 3 per cent.

Sayuri Shirai is Professor at Keio University and a former policy board member of the Bank of Japan.

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