Key Takeaways
- Rising underlying inflation, wage growth, and global interest rates are strengthening the case for a normalization of Japan's monetary policy.
- Tightening could include adjustments to the yield curve-control framework, as well as some increase in the policy rate.
- Given the low inflation of recent decades, high government debt, and potential for significant market implications, the Bank of Japan (BOJ) is likely to move carefully and cautiously.
After a long period of very low interest rates in Japan, market expectations of monetary policy normalization are rising. Higher inflation and global interest rates are putting pressure on the Bank of Japan (BOJ) to abandon its ultra-accommodative monetary stance. The BOJ's policy rate has been close to zero since 2008, and less than zero (-0.1%) since 2016.
The bank has also pursued a yield curve control (YCC) policy, under which it commits to buying government bonds to maintain 10-year government bond yields at "around 0%." With the BOJ having become an increasingly large holder of this paper, financial markets tested its commitment at end-2022. As a result, the bank raised the margin of the band around the center of 0% to 50 basis points (bp) from 25 bp, effectively increasing the cap to 50 bp. Since then markets have left the target largely unchallenged (see chart 1).
The case for a move toward normalizing monetary policy has strengthened because of further increases in underlying inflation and expectations for yet higher U.S. interest rates. Japan's "core core" inflation (stripping out energy and food prices) rose to 4.3% in May, the highest level since the 1980s. The increase in inflation since 2021 was initially triggered by higher energy and commodity prices. And it was amplified by a large depreciation of the yen against the U.S. dollar amid the monetary-policy divergence.
But second- and third-round effects via pass-through of cost increases and higher wage growth have also increased core core inflation (see chart 2).
Chart 1
Chart 2
Expectations of higher U.S. interest rates have manifested in another bout of yen depreciation in June, after markets realized U.S. Federal Reserve policy will have to stay higher for longer. The yen gained ground in July on expectations of BOJ policy adjustment and easing U.S. inflation.
The Case For Caution
The bar for a monetary tightening is high, given the low inflation of recent decades and high government debt. Japan's gross government debt stood at 261% of GDP at end-2022; net government debt was 162% of GDP at that time. In these circumstances, rising interest rates in the absence of higher inflation for longer and nominal growth would unduly increase interest burdens.
Indeed, if interest rates rise while inflation falls back to low levels, the downside could go beyond an unwelcome economic slowdown and trouble among some corporates. It could trigger a fiscal calamity (see "Japan's Credit Risks Could Rise With Costlier Financing If Growth Falters," published on RatingsDirect on Feb. 23, 2023).
The Japanese Ministry of Finance has estimated that, if interest rates exceed the government's current assumptions by 1 percentage point, debt service costs in fiscal year 2026 would be ¥3.6 trillion greater than the government's baseline estimate (about 0.6% of GDP that year). If such an increase in interest payments is not offset by a rise in revenues--because inflation doesn't go up--then interest costs rise in real terms and as a share of GDP.
The longer-term impact, after expiring debt is refinanced at higher interest rates, would be even larger. We estimate that if the real (inflation-adjusted) effective interest rate on government debt rises by 1 percentage point, the government's interest costs would increase by 1.6% of GDP. This results from a rise in nominal interest rates paid by the government not matched by higher inflation and thus higher nominal GDP growth.
In our view, the BOJ is keen to avoid such a scenario. Following his first policy meeting in April, Governor Kazuo Ueda said that "the risk of missing a chance to achieve the 2% [inflation] target as a result of premature policy tightening is greater than the risk that inflation remains above 2%.
Thus, S&P Global Ratings expects the BOJ to remain very careful, tightening monetary policy only if it sees evidence that the rise in inflation will be sustained. Sustained higher inflation increases revenues of the government and corporates, offsetting the impact of higher nominal interest rates. If inflation and (effective) interest rates rise in tandem, the unfavorable impact would be negligeable for economic growth and the government's interest expenditures. This is why the BOJ is insistent on a sustained rise in inflation towards the 2% target as a condition for raising interest rates.
Conditions Are Emerging For Some Monetary Policy Adjustment
As stressed by the Bank of Japan, the key to a sustained rise in inflation is sustainably higher wage growth. The recent rise in inflation has been largely driven by higher input costs. Yet this spring's "Shunto" wage negotiations round has resulted in significantly higher wage growth than in recent years. Amid a tight labor market, more firms seem willing to offer higher wages to attract younger people, even at the risk of eroding the long-established largely seniority-based labor market arrangement (see "Why Japan's Consumer Inflation Will Drop Back Below 2%," Sept. 7, 2022). The big question is to what extent overall wage growth will rise sustainably. But momentum is picking up.
Inflation forecasts for 2023 and 2024 have risen. The July Focus Consensus forecast was 2.7% for 2023 and 1.6% for 2024, with the latter up 0.2 percentage points compared with April. As a sustained rise in inflation increases revenues for the government and corporates, it should provide some room for normalizing the monetary policy stance. We expect the BOJ to make some adjustments to the yield curve control framework. We also anticipate an increase in the policy rate to +0.1% later this year or in 2024, from the current -0.1%.
The BOJ will need to be very careful in its communication around monetary policy normalization and forward guidance, to prevent disorderly developments in financial markets.
A Medium-Term Perspective On Interest Rates
Empirical research suggests that the "neutral" interest rate, the rate that would balance demand and supply of financial resources in the economy, has remained low in advanced economies, especially in Japan. Research reported in the IMF's April 2023 World Economic outlook found that Japan's real equilibrium interest rate has remained around -0.6%. Factoring in 1.5%-2% inflation, this would imply a nominal neutral interest rate of around 1%-1.5% in a few years.
While that is significantly lower than the neutral rates in the U.S. and Europe, it indicates the potential scope for increases in coming years.
The initial steps toward normalization of monetary policy in Japan will be small, and the country's interest rates are likely to remain well below those in the U.S. and Europe. But for the first time in a long while, the BOJ may depart from its ultra-accommodative monetary policy.
Related Research
- Japan's Credit Risks Could Rise With Costlier Financing If Growth Falters, Feb. 23, 2023
- Why Japan's Consumer Inflation Will Drop Back Below 2%, Sept. 7, 2022
This report does not constitute a rating action.
Asia-Pacific Chief Economist: | Louis Kuijs, Hong Kong +852 9319 7500; louis.kuijs@spglobal.com |
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