What Could Tightening By The Bank of Japan Look Like?
How Might The Markets React?
If there’s one thing that the markets have taken for granted over the past 15+ years, it’s that the Bank of Japan will keep monetary conditions as ultra-accommodative as possible. After lifting its benchmark rate all the way up to 0.50% in 2007, the central bank quickly cut back to 0% coming out of the financial crisis and has tested the effectiveness of a -0.1% interest rate since 2016.
It’s kept those conditions for as long as it has because the economy hasn’t been able to generate sufficient growth or inflation in order to warrant anything else. Over the past 25 years, Japan has generated a full year GDP growth rate above 2% just four times. Two of them came during the post-financial crisis and post-COVID rebounds. The other two came in 2000 and 2004. The economy might yet clear the 2% mark in 2023, but a -0.7% GDP print in Q3 puts that in danger. The same goes for inflation. Since 2000, Japan’s inflation rate has typically hovered around the 0% level with few instances of clearing even a modest 2% goal.
Japan might now finally be entering a new regime.
Thanks to the global inflation cycle over the past two years, Japan’s inflation rate has been above 2% for nearly two straight years. Both the headline and core rates are currently around the 3% range and may actually stay there for a little while. GDP growth has, admittedly, been a little on the weak side, but it’s not yet at the level that would indicate a high risk of recession at the moment, at least by traditional definitions.
For the first time in years, the Bank of Japan might actually have a decision to make.
The last hang-up looks like it’s going to be wage growth. The BoJ is looking for sustainable inflation and that’s going to require strong wage growth to support it. Annualized wage growth has been somewhere in the 1-2% range over the past three years and the central bank wants it above 2% consistently to feel comfortable that inflation can remain at 2% or above. Right now, it’s still not there. That makes the timing uncertain for when the BoJ will feel comfortable that the economy has achieved this in order to begin tightening.
Bank of Japan President Ueda thinks we’re getting close though. In fact, he sent the markets into a bit of a frenzy when he spoke about options for exiting the central bank’s negative interest rate policy. Previously, Ueda had talked about giving current conditions a harder look around year-end to try to make a determination if it was time to finally end ultra-loose monetary policy. The markets took that to mean a shift could be imminent, but the BoJ walked back those comments this week indicating that nothing was yet on the table in the short-term.
To be certain though, it’s on the radar and it will be for investors too until the next policy shift is made. With the central bank’s yield curve control policy getting eased more than once over the past year, the process of tightening has already unofficially begun, just in baby steps. I believe that it’s probably more likely than not that the BoJ makes another change to yield curve control (or eliminates it altogether) before hiking interest rates, but it’s unclear what the BoJ has in mind. At this point, we’re largely left to speculate what it could look like.
That means it’s time for a little thought experiment. What happens if the Bank of Japan surprises the markets and decides to tighten policy this month? Will it get rid of yield curve control? Will it raise interest rates? Will it do both? Will it do neither?
Let’s look at some purely hypothetical scenarios and examine how they might play out for the financial markets.
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