Japan’s interest rate increase raises questions of volatility

Japan has ended its strategy of negative interest rates, ending more than a decade of loose monetary policy.  

The Bank of Japan has increased overnight lending rates to a range of 0 per cent to 0.1 per cent, an increase on the previous range of minus 0.1 per cent to 0 per cent. It is the first time the BoJ has increased rates in 17 years, seeing the end of the negative rates policy introduced in 2016. The decision also makes it the last central bank to abandon negative rates.

The policy changes also mark the end of yield curve control, which had seen 10-year Japan government bond yields set at around 0 per cent. Exchange traded funds and Japanese real estate investment trust purchases have also been abolished. However, the BoJ will continue its policy of buying around Y6tn ($40bn) of government bonds each month.

The move came after wage negotiations which saw Rengo, the Japanese Trade Union Confederation that represents seven million workers across Japan’s biggest employers, win an average 5.28 per cent wage increase, the largest since 1991. Shigeto Nagai, head of Japan economics at Oxford Economics, said the wage increase was “surprisingly strong”.  

The BoJ has stated for some time that it will only raise rates if it expects inflation to stay at 2 per cent or above. The strong wage increases seem to have been the tipping point, but Ulrich Volz, professor of economics at SOAS University of London, said these wage increases do not apply to small and medium-sized companies, which employ around 70 per cent of Japan’s workforce.  

Nagai noted that while the BoJ recognises there is uncertainty about the sustainability of a wage-driven inflation process that still requires accommodative policy, there was a desire to return to a more orthodox policy framework, centred on the control of short-term policy rates.  

In a note, Alicia García-Herrero, chief economist for Asia-Pacific at Natixis, cautioned that ongoing wage negotiations will determine if the 2 per cent inflation target can be reached in a sustainable way. She said the data is showing weakened industrial production, lower consumer confidence, and softer underlying inflation. The decision of the Fed to further delay cuts could further negatively impact the situation.  

The BoJ will be conscious of the need to limit the impact on the real economy and sustain wage-driven inflation, said Nagai. He added that the BoJ will look to minimise the impact on bank lending rates by guiding the short-term money market rates close to 0 per cent, and try to contain market speculation on rate hikes.  

The decision to increase rates may bolster the yen, which has been weak for several years. However, following the announcement, the yen weakened 0.8 per cent against the US dollar. In a note, García-Herrero stated the decision to continue purchasing government bonds at the same rate will mean the balance sheet continues to grow at the same pace, which may negatively impact the yen.  

Volz cautioned that rising interest rates may lead to a strengthening of the yen, reducing the cost of imports and increasing the cost of exports.  

In the bond markets, Nagai noted the decision to end negative rates and yield curve control will likely have limited impact, as the “majority of market participants share the BoJ’s argument that a zero-interest-rate policy will continue in the coming quarters”.  

He said that if the prospect of wage-driven growth rises, long-term yields will start to price in the further hikes and term premium will increase, reflecting the uncertainty over the outlook for inflation and monetary policy.  

“Bond markets are vulnerable to risks arising from the coming exit process from quantitative easing and the projected deterioration in a fiscal situation. Higher and more volatile long-term yields will drive price dynamics of other asset markets such as equity,” added Nagai.  

However, the end of yield curve control and negative rates may prove beneficial to regional banks, said Nagai, due to higher lending margins and a more stable return from the bond portfolio, thanks to the steeper yield curve.  

Outside of Japan, any increase in the value of the yen will likely benefit Japan’s export competitors such as China and South Korea, said Volz, as exports become comparatively cheaper. 

“Rising rates in Japan may trigger an unwinding of the carry trade in which investors borrow in cheap yen to invest abroad,” he added. “As Japanese investors shift from foreign to domestic assets, this could lead to rising global bond yields.”