Japan’s Big Bet on Interest Rates May Not Pay Off

Japan’s central bank, the Bank of Japan (BOJ), made global headlines in March with a bet that the deflation-ridden economy had finally turned a corner. The question now is whether the economy will do its part.

Bolstered by a stronger economy and steady wage growth, the BOJ drew a curtain on one of the longest-running monetary policy experiments in history, ending 11 years of an unconventional monetary easing that was aimed at reversing seemingly intractable deflationary pressures.

BOJ Gov. Kazuo Ueda announced the changes following a two-day meeting of the policy board on March 18-19. The central bank not only ended its negative interest rate policy that set short-term rates below zero but also terminated its buying of stock funds and its yield curve management program.

Together, these constituted the “bazooka” put in place by Ueda’s predecessor, the eternally optimistic Haruhiko Kuroda, who came into office in 2013. Kuroda had a bold plan to create a low but sustainable inflation rate, vowing to succeed where prior governors had failed since the mid-1990s, when prices and wages seemed to enter a time warp. His plan was to create 2 percent inflation in two years by doubling the bank’s monetary base.

Reality was a bit different. The 2 percent target now seems in place (although it may turn out to be closer to 1 percent), but it took more than a decade and saw the balance sheet balloon 4.5 times over the period to a record 760 trillion yen ($4.9 trillion)—a figure that is larger than Japan’s total annual economic output.

As flashy as the news was, the change was not that great. The BOJ will now target the interest rate on the benchmark 10-year Japanese government bond at 0-0.5 percent, a move best described as a “normalization” rather than a real monetary tightening. It’s usually overheating that prompts central banks to raise rates, but the Japanese economy is warm at best. Growth continues to be modest by global standards, and the economy narrowly avoided falling into a recession in the final three months of 2023.

Yet the policy change was significant in signaling that a global rise in input prices had been succeeding in creating inflation where years of monetary policy easing had largely failed. The most positive aspect was the recognition that wage growth, which had largely flatlined in the past 30 years, was now showing signs of life. With the multitude of economic shocks from the COVID-19 era, the closely watched “spring offensive” for union wage negotiations went up 3.6 percent in 2023, but this failed to create much good cheer, given that real wages continued their two-year losing streak with a 2.5 percent fall in 2023, the biggest drop since 1990.

This not only hit people’s pocketbooks but also helped drive down the approval ratings for Prime Minister Fumio Kishida, a generally likable figure whose primary failure has been to be in the wrong place at the wrong time.

It also reminded policymakers who had for years decried the evils of a deflationary economy that for the average person it wasn’t all that bad. Even though wages were stagnant, prices fell steadily if slowly from their 1990 bubble economy peak, meaning that paychecks stretched a little further each year. The problem was for wealthier Japanese, who saw their savings earn little in the way of return.

The landscape for 2024 has proved rosier. The spring round of talks produced wage gains of 5.3 percent, the highest in more than 30 years and enough to beat continuing but generally tame inflation of around 3 percent. The BOJ, looking for an exit ramp from its balance sheet bloat, seized on the news and announced, more quickly than many economists had predicted, that it would be ending Kuroda’s guinea pig project for Japan’s economy.

From an external perspective, the BOJ move has been a reaffirmation that Japan is now the place to be. Investing legend Warren Buffett, as is often the case, signed on early, having invested an initial $6.7 billion in Japan’s five major trading companies in 2020, upping the stake to around 9 percent this year. Others have jumped on, pushing Japan’s stocks above the 1990 peak that came to epitomize the country’s once overinflated bubble economy.

BlackRock CEO Larry Fink said in March that Japan’s economy appears to have turned a corner. “We are overweight in Japan, and our investors like the overweight,” he told Japan’s Nikkei newspaper, adding that he believed higher interest rates would actually help growth. “Having higher interest rates on your savings will stimulate more consumption, and that’s what Japan needs.”

But the domestic view is less optimistic. Some economists say the decision had little to do with confidence in the economy and was actually triggered by a sharply weakening Japanese yen, which has fallen 15 percent against the dollar in the past year and plummeted 50 percent since Kuroda’s easing program began in 2013. “The action was clearly driven by the yen. The economy has been slowing down—it just scraped by avoiding a recession. This is not a situation where you tighten,” said Martin Schulz, the chief economist for the electronics group Fujitsu. Higher interest rates tend to increase a currency’s value, although the markets have taken the opportunity to send the yen even lower.

Japanese economists also point out that despite the fanfare, the yield on the benchmark 10-year Japanese government bond has remained at just 0.8 percent.

And while there is enthusiasm about economic prospects, pessimists have plenty of negative data points on hand, especially in relation to Japan’s longer-term prospects. Japan has been a world leader in creating an aging society, with the population shrinking at a 0.5 percent rate. Even if Japan manages to come out of its aversion to mass immigration, society will have to change sharply.

The BOJ action is also a warning shot aimed at the government and its free-spending ways. In the years of Kuroda’s monetary easing, the central bank bought virtually all new debt that the government issued, pushing Japan’s already lofty government debt burden higher, to an estimated 264 percent of annual GDP, far above the level of any other functioning economy. Even a slight nudge higher in interest costs for the government will pose new problems as the Kishida government tries to keep up with growing social insurance costs while promising to sharply increase defense spending by somewhere between 60 and 100 percent over the next five years as the country faces a growing China threat.

There is also a hidden problem for the BOJ’s own finances. In the Alice in Wonderland world of negative rates, the BOJ charged commercial banks for depositing their money at the central bank, producing a tidy revenue stream. But now the BOJ will return to the more conventional notion of paying interests on such deposits, meaning a revenue source now becomes a cost.

The bigger issue is how the BOJ can extricate itself from its massive holdings while helping a fragile economy to grow even as stimulative government spending becomes more costly. “It will be difficult because the economy is so dependent on government spending,” Schulz said. “In terms of normalization, this is now the first step on the road. But it is a very long road.”