Japan’s Ultra-Loose Monetary Policy

By Poorvi Hosabettu

Introduction 

During and after the COVID-19 pandemic, governments around the world rapidly increased expenditures to expand social security nets, fund their stagnant economies, and feed and vaccinate their people. The consequences of this increased spending have been hitting economies since 2022, a time lag effect of inflation and unaffordable consumer prices. Central banks around the world have tightened their economy by rapidly raising interest rates (Martin, 2023) to curb this inflation, but the Bank of Japan (BOJ) has maintained a uniquely loose monetary policy. This paper will explore the causes and consequences of such a policy and the potential outcomes of abandoning it. 

History 

From 1993-2003, the Japanese economy had stagnant GDP growth of 1% and deflationary trends. Called the “lost decade of Japan”, the period was characterized by serious economic slowdown – where investors hoarded funds instead of investing them – all caused by the burst of the Japanese real estate bubble. At the time, Japanese monetary policy was already responding to rising inflation by raising interest rates, and in response to the rise in consumer prices due to the crisis they tightened the economy further. This was blamed for causing the economy to spiral downward and inevitably led to a liquidity trap. The BOJ’s solution of slashing interest rates and reinjecting funds into the economy by increasing the money supply gradually revived Japanese investor confidence and the economy overall (Nielsen, 2022). 

In a joint statement from the BOJ and the Japanese government in 2013, they state their primary goal is "aimed at achieving price stability, thereby contributing to the sound development of the national economy", and as such, they set a goal of 2% change in consumer prices by CPI (Outline of Monetary Policy : 日本銀行 Bank of Japan, n.d.). 

To that end, Japan’s interest rate has been negative (-0.1%) since 2016 (Japan Interest Rate Decision, n.d.). As a result of this policy, Japan’s mortgage rates are some of the lowest in the world, an active response to the crazy housing bubble of the early 2000s crisis. 

Post-pandemic repercussions

While Goldman Sachs believes that Japan’s ultra-loose monetary policy – called Yield Curve Control (YCC) – is likely to be abolished sometime soon, this is open to contention. Inflation has finally hit Japan at 3.3%, and although it is still lower than many larger developed countries (Japan Inflation Rate, n.d.), it is higher than its 2% goal. The surge in the American dollar (and the consequent drop in the value of the yen) has made imports more expensive for Japan, where food and fuel are import-dependent and thus struggling. Japan has upped its bond cap, but foreign investors have lost confidence in the Japanese market and have pulled out of Japan in droves (Martin, 2023). 

The BOJ now faces a mountain of problems after a decade-plus of quantitative easing, that is, the government injecting funds into the economy by buying bonds to stimulate economic growth. Recently, the central bank purchased $90 billion worth of bonds in just 4 days, the largest bond purchase in Japanese history (Sposato, 2023). Japan’s large debt-to-GDP ratio (261.13% as of 2023) leaves the country liable to fulfill an impossible debt if they raise interest rates too quickly. 

New BOJ Governor

The recently nominated and now incumbent BOJ governor, Kazuo Ueda, is entering the game at a tumultuous time in Japanese economic history. An academic economist, Ueda’s selection was unusual as BOJ governors are usually picked from former Ministry of Finance bureaucrats. He’s coming into office after his predecessor, Haruhiko Kuroda, spent a decade steering the country’s growth with aggressive monetary easing.

His first priority on the job is expected to involve reigning in the inflation rate and re-stabilizing prices to the former 2% cap (Fensom, 2023). There is speculation that Ueda disagrees with the previous governor Kuroda’s approach, and might gradually adjust the country’s monetary policy to reach the target but also later accommodate price hikes.  That said, Ueda stated at his confirmation hearing that he intends to maintain monetary easing by waiting it out until demand lowers inflation; still, critics see side effects that might not allow such a laid-back approach (Shirai, 2023). 

In an effort to maintain the yield cap of under 0.5%, the Japanese government has been forced to purchase a significant amount of bonds as a “buyer of last resort” (Sposato, 2023). The Japanese government now owns 54% of outstanding government bonds, and this has caused the yen to be pushed lower. The burden of monetizing this debt without destabilizing markets now falls on the new BOJ Governor’s shoulders. In a paper Ueda wrote in 2012, he predicted the excess reserves in the BOJ’s account due to debt purchases will make any monetary tightening difficult in the future. Currently, Ueda has yet to explicitly express how he wishes to mitigate these side effects, but has acknowledged concern over their growth (Doi, 2023).

Potential outcomes:

Despite pandemic-induced inflation, demand is high in Japan, with Japan finally opening back up for tourism this year; hotel, restaurant, and tourist attraction reservations are fully-booked months in advance (Dooley and Ueno, 2023). There is a good chance that gradually inflation will be battled by high consumer demand alone and automatically normalize. 

Another problem Japan faces in the short-to-medium term is its demographic issue. Japan’s low birth rate for the past few decades has caused an increase in the elderly population but a dearth in the middle-aged working population. The elderly population depends on social security programs funded by the taxes of the middle-aged working group, who are further disincentivized to have children due to these very economic pressures. This demographic problem is a bad forecast for Japan’s economic growth and productivity (McElhinney, 2023), with labor shortages potentially making it harder to battle rising inflation. 

The abolishment of the YCC in any capacity would inevitably lead to a stronger yen and increase investor interest in the Japanese market (Could Japan Unwind a Key Part of Its Ultra-Loose Monetary Policy?, 2023). But there are other side effects that are likely to ripple through the nation and have lasting problems for its population. Japan has avoided the housing crisis that several countries have faced post-pandemic, but this comes with its own set of problems. Negative interest rates have caused a majority of borrowers (70%) to take out variable-rate mortgages, meaning that the abandonment of Japan’s loose monetary policy and even a slight increase in interest rates could spell disaster for Japanese homeowners and borrowers (Spiro, 2022). 

Will Japan abandon the YCC?

The BOJ insists that the current inflationary period (which is above their preferred goal of 2%) is transitionary and due to supply inefficiencies (Could Japan Unwind a Key Part of Its Ultra-Loose Monetary Policy?, 2023). With current trends of financial instability in the US and Europe, the BOJ benefits from maintaining the status quo in Japan (Shirai, 2023). Tightening monetary policy will likely reduce asset values to banks, who will then be less likely to lend out money, negatively affecting Japanese economic growth. The BOJ made a similar mistake of raising interest rates too early in 2000, a mistake it is unlikely to want to repeat. 

Ueda’s stated goal of maintaining the 2% price stability target is likely in contrast to market expectations. He is likely going to have to increase communication with the market and the public on the BOJ’s goals and plans to ensure the monetary policy measures that the BOJ has been practicing so far can be maintained. 

The primary objective of raising interest rates right now is to battle inflation. The current prognosis is that Ueda will maintain the course on monetary easing for now, but eventually move away from traditional frameworks to introduce policy more adaptable to monetary tightening in the future - potentially by reducing the BOJ’s “bloated balance sheet” (Shirai, 2023).

If they do drop the YCC, analysts predict a conservative shift and more forward guidance – the bank actively communicating with the market about its future moves – and letting the market decide the rates of long-term bonds instead of controlling it through open-market operations and purchases. Regardless of the incoming governor’s stance, Japan is poised at a point in history where it can more safely move to monetary policy normalization.  

References

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Dooley, B., & Ueno, H. (2023, February 14). Packed With Tourists, Japan Returns to Economic Growth. The New York Times. https://www.nytimes.com/2023/02/13/business/japan-economy-gdp.html

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McElhinney, D. (2023, February 28). Why money will not be enough to address Japan’s baby crisis. Www.aljazeera.com. https://www.aljazeera.com/news/2023/2/28/why-money-will-not-be-enough-to-address-japans-demographic-crisis#:~:text=Japan%20is%20facing%20one%20of

Nielsen, B. (2022, January 14). The Lost Decade: Lessons From Japan’s Real Estate Crisis. Investopedia. https://www.investopedia.com/articles/economics/08/japan-1990s-credit-crunch-liquidity-trap.asp#:~:text=Japan

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Spiro, N. (2022, December 5). The blessing and curse of Japan’s crazy low mortgage rates. South China Morning Post. https://www.scmp.com/comment/opinion/article/3202070/blessing-and-curse-japans-crazy-low-mortgage-rates?module=inline&pgtype=article

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