Has Japan escaped deflation?

Japanese economy has been battling with deflation after the burst of property and stock market bubble in 1990s. Since then Japan has been facing a period of prolonged and secular decline in the prices leading to wage stagnation and sluggish economic growth. Japanese economy grew at less than 1% on average in the last 25 years. A series of fiscal & monetary policy measures were employed to pull the economy out of stagnation. The country’s central bank, Bank of Japan started to ease the policy rates to counteract the deflationary pressures in the economy.

In 1999, BoJ became the first post war central bank to cut the interest rates to zero to revive the economy. The central bank had kept the borrowing rates low to encourage the businesses & households to spend & invest to boost the domestic economy. In 2016 for the first time, Bank of Japan turned to negative interest rates - an unconventional monetary policy measure - to stave off the deflation in the economy.

On March 19, BoJ has raised the key policy interest rates to 0 - 1% from between (-) 0.1% and 0 % for the first time since 2007, becoming the last central bank to end the unorthodox negative interest rate policy. The recent move by the central bank ends the long standing Japanese policy of negative interest rates meant to fight the deflation

BoJ's Pivot Away from Negative Rates

Bank of Japan has introduced Quantitative and Qualitative monetary easing (QQE) with yield curve control in 2016, a new framework for easy money policy. The QQE with yield curve policy consists of two components: the first is "yield curve control," in which the Bank controls short- and long-term interest rates through market operations; the second is an "inflation-overshooting commitment," in which the Bank commits to continuing to expand the monetary base until the year-on-year rate of increase in the observed CPI exceeds 2 percent and stays above the target in a stable manner.

But on March 19, BoJ abolishes the yield curve control reverting to the normal monetary policy targeting of short term rates like other central banks. BoJ ended it’s inflation overshooting commitment as it has fulfilled the conditions for its achievement. The 1% capping of the 10 year Japanese Government Bonds (JGB) was also removed. BoJ has also put an end to the purchases of exchange traded funds and Japanese real estate investment trusts (REITs) accompanied by a gradual reduction in purchases of commercial paper and corporate bonds and discontinuation of the purchases in one year. While the central bank has embarked on a monetary tightening trajectory, it has signaled a commitment to maintaining a degree of policy accommodation, precluding the risk of an overly restrictive stance.

Drivers Behind the BoJ's Policy Shift

Japanese economy has averted a technical recession due to upward revision in fourth quarter GDP for 2023. Though Japanese economy has recovered moderately although weakness is visible in certain sectors like exports due to the weak external demand and the industrial production as well remain flat.

Since April 2022, consumer price inflation (CPI) has persistently surpassed the 2% target. Initially driven by external factors viz, energy price rise due to Russia-Ukraine conflicts, the inflationary environment transitioned to domestic demand-pull factors. Rising wages and the pass-through of higher production costs to consumers fueled this shift, prompting a policy reversal by monetary authorities. The ongoing wage Shunto wage negotiations with the major unions have resulted in a substantial increase in total wage growth this fiscal year (FY24), averaging 5.3 percent. This marks the highest wage growth rate in last three decades and is fueled by a strong 3.7 percent increase in base salary. These figures are both significantly higher than previously anticipated.

Implications of the BOJ's Move

The normalization of monetary policy signals the end of deflationary pressures that had worried Japan for the last three decades. The signs of recovery in the domestic economy with resilient private consumption and rising wages will boost the confidence among various economic agents resulting in a pick up in private capex. The rise in policy rates would incentivize at least some local investors to bring funds home as interest rates start rising. Policy rate hikes can lead to a stronger yen making it more attractive for global investors.

Japanese 10 year bond yields have anchored between 0.7% and 0.8% post the policy announcement. Significant reallocation of global capital flows may not take place without substantial rate hikes in the future. Corporates profits might take a hit in the upcoming quarters due to higher borrowing costs and business investments which is already flat might decline as a result of increased cost of capital. The public debt to GDP ratio in Japan is already high at ~263% of GDP - increasing the interest burden on the country.

The recent monetary policy changes in Japan warrant close attention to their implications across several key fronts: capital account dynamics, public sector borrowing costs, the external sector, and in the financial markets.