Even as its liquidity provision passes its 25th year, the Bank of Japan looks unlikely to tighten monetary policy in step with other central banks until deflation is beaten and the Ministry of Finance can end its reliance on ultra-low yields to control government debt costs. Neither of these looks likely to happen in the new governor’s five-year term starting on 9 April, and possibly beyond it.

This dependence was evidenced in November when the BoJ intervened to support the yen as rates rose elsewhere. It was followed in December by the only 25 basis point rise in the bank’s 10-year government bond yield target, to 0.5% – its second token rise since introducing a target in September 2016 (initially set ‘close to zero’). The rise came as market vigilantes questioned the BoJ’s resolve after months of rate increases and quantitative tightening by the US Federal Reserve and Bank of England, and as the European Central Bank prepared to supplement higher rates with QT.

Figure 1. BoJ holds more than half of Japan’s government bonds

JGBs outstanding in ¥tn on left-hand axis, BoJ & domestic banks’ % shares on right

Source: Refinitiv Datastream, based on BoJ data

In January, the BoJ not only clung on to the 0.5% cap against speculation it would abandon it, but also forcefully added liquidity, with an unscheduled ¥1.4tn ($11bn) of quantitative easing across maturities. Pressure for more will build. Unless coordinated with other central banks (which is unlikely while they tighten), Japan’s yield targeting was always going to be tested.

Further changes may be needed, the bulk of which could be deferred till after BoJ Governor Haruhiko Kuroda’s tenure expires in April. The surge in QE under Kuroda, as architect of yield targeting in 2016, leaves the BoJ holding over half of Japan’s government  bond market (Figure 1). Markets will anticipate a less dovish stance, so changing the target later this year would both ease pressure and allow officials to infer they are ushering in a ‘new era’.

But resistance will remain to any wholesale changes that threaten Japan’s ultra-loose monetary conditions and low bond yields. At the global level, pressure should be reduced anyway as markets increasingly anticipate the peak in policy rates elsewhere. Having gone relatively hard on rate hikes into the northern hemisphere winter, the summit for US and UK rates might come in late spring as the growth hit from stagflation becomes more visible. The ECB, as a QT laggard, may peak later.

Second, Japan’s authorities still have every incentive to keep the policy reins loose. Deflation has precluded nominal gross domestic product from passing its 2008 level. And, given Japan’s excessive government liabilities – at 250% of GDP, the developed world’s highest – government debt ratios and funding costs need to stay down. Expect little reversal of the MoF’s massive fiscal stimulus during Covid-19 (equivalent to 23% of GDP), and little prospect of QE ending.

Figure 2. Yen weakness, if sustained, offers future trade benefits

Japan trade surplus with US (rolling 12-month total, $bn), lagged 1 year, versus $/¥ on inverted axis. Blocks denote US (grey) and Japan (orange) recessions

Source: Refinitiv Datastream

Global inflation may be elevated, but the uplift in Japan does not yet look convincing. Even though Japan’s consumer price index has, in line with global pressures, returned to positive territory (an average +2.0% year on year since September 2021), its more representative, economy-wide GDP deflator has stubbornly failed to rise (averaging -0.2% yoy). This absence of inflation (the GDP deflator is used in debt/GDP ratios) does little to erode the real value of government debt.

Third, past practice suggests the MoF is unlikely to endorse any candidate advocating a strong policy-tightening path (Kuroda started his career at the MoF in 1967). Prime Minister Fumio Kishida is expected to announce Kuroda’s successor on 8 February. And, for as long as the MoF craves inflation and growth, the gains to export competitiveness from a weaker yen will be welcomed. OMFIF analysis suggests it takes up to a year before the full benefit from yen weakness against the dollar is reflected in Japan’s bilateral trade surplus (Figure 2).

Most likely, as quid pro quo for raising the target again, the BoJ will have to increase its QE. By virtue of the target, any QE rise as a result of global forces should be seen as a relative loosening. Part of the logic is that extending QE and delaying short-rate rises beyond the asset purchase schemes of other central banks leaves domestic institutions looking overseas for yield, further softening the yen. This led some officials to concede, long before Covid-19, that the BoJ would be the last to stop QE.

Will continued QE help? The main benefit of Japan’s QE has been to suppress long yields and, thus, debt-service costs. In the late 1980s Japanese asset prices ballooned, stylised by the valuation of the emperor’s palace grounds (at $139,000 per square foot) surpassing that of California’s total real estate. Tumbling asset prices from 1991 hurt banks’ balance sheets and collateral, spurring economy-wide deflation by 1995. This prompted banks to write off loans, and the BoJ between 1997-98 to mop up their commercial paper (regarded as ‘QE1’).

Figure 3. QE’s transmission mechanism globally has been less than perfect

Estimated money velocity: ratios of nominal GDP to broad money supply. Grey is US recession

Source: Refinitiv Datastream

The MoF became reliant on the BoJ to control its debt-service costs, including from March 2001 via JGB purchases. But its transmission mechanism has been woefully slow. The responsiveness of GDP to money growth has been less than the one-for-one hoped for. In reflation terms, it’s no good throwing money out of a helicopter if no one spends it. With consumers and firms concerned about unemployment, margins and/or deflation, velocity has been slow to recover. And this has been true for the other QE economies that followed suit (Figure 3).

Critically, this relative insensitivity of demand to money growth suggests any inflation spawned by QE came more by inflating asset prices than the direct consumer route hoped for. QE thus came to act more like a tax than a subsidy and, as demand stuttered, central banks increased QE, creating a vicious circle that cannot be broken without unintended consequences.

These observations do not bode well for other high-government-debt economies like the US, euro area and UK, whose central banks may struggle to reduce their balance sheets. Their central bank independence already looks blurred. With fiscal costs now a growing consideration in monetary decisions, Japan may still be the best test case we have.

Neil Williams is Chief Economist at OMFIF.