The Bank of Japan shocked the markets by raising interest rates for the first time since 2007, increasing the short-term rate by ten basis points to a range of 0-0.1%. On March 19, 2024, the Bank of Japan (BOJ) ended a decade-long experiment with negative interest rates.
The main reason for this was that, as the governor noted, "the largest firms in Japan have recorded the biggest wage increases for over three decades," while, at the same time, "core inflation was firmly around the two percent threshold for the last year." These two factors, namely, rising wages and stable prices, offset the forces pushing the country toward another prolonged period of deflation.
Why did the Bank of Japan raise rates?
While the new governor of the BOJ, Kazuo Ueda, signaled the end of the era of negative rates when he took office in 2023, the reason why the rates were increased was the improvement in the labor market. Specifically, the data from the largest labor federation in Japan showed that wages rose over five percent year-on-year, reaching the highest level since the early 1990s. The increase in wages was driven by the so-called "wage-price spiral." This, together with the fact that the sequential pressures on prices seemed to peak, convinced the BOJ that it was a good time to exit the unconventional monetary policy.
How did financial markets react to the news?
As the markets expected the central bank to tighten its monetary policy at some point this year, the news caused mixed reactions. First of all, the Japanese yen depreciated slightly against the dollar after the announcement. In addition to the weak performance of the yen, Japanese government bond yields also rose. However, the dovish statement from the BOJ about moderate tightening allowed the markets to breathe a sigh of relief. In particular, the central bank reassured investors that it would maintain an accommodative stance for the time being, which means that rates would not increase for some time.
What will happen next?
For now, the BOJ decision should be seen as the beginning of the end, as the gradual tightening of monetary policy will allow the central bank to exit the liquidity trap. In this regard, it is necessary to monitor the purchases of government securities by the BOJ, which will remain at the same level as before. This should help maintain stability in the markets, as the yen weakness and the bond yield increases may be limited by the slow tightening. At the same time, it is unlikely that the BOJ will quickly resort to further rate hikes. The central bank will wait for signs that inflation will remain at the two percent threshold. The key indicator that the BOJ will monitor will be the growth of wages since, according to recent data, this growth will be significant and broad.
For the central bank, which has been waging a desperate battle with deflation for the entire tenure of the current government, the prospect of gradually returning to normal monetary policy by slowly returning to positive deposit rates is definitely a positive scenario.