For years, the Bank of Japan (or BoJ) was an outlier in the global central banking system, in its persistent efforts to stimulate the expansion of monetary policy. While the world's monetary authorities were aggressively raising interest rates in an effort to combat rampant inflation, the BOJ was suppressing the yields of 10-year government bonds. Yield-curve control (YCC)—the term that few outsiders understood—was ultimately abandoned by the BOJ in March 2024, in the same monetary policy meeting when the BOJ abandoned its experiment with negative interest rates.
The reason for the reversal was hardly surprising—the tightening of monetary policy that began in March 2023 had been in force for almost two years. The YCC framework, which was lifted by the new Governor Kazuo Ueda, was enacted back in 2016 and marked the longest experiment within the post-2008 monetary easing cycle. Its termination was consistent with the BOJ's history, which saw three governors change in the meantime.
How we got here
The central bank committed itself to YCC in 2016 to prevent prolonged decline in long-dated interest rates from undermining its ability to control inflation. In practice, the commitment involved large-scale bond-buying by the BOJ to keep the yields of Japanese Government Bonds (JGB) around 0%. Despite the apparent success of this approach, the YCC resulted in several negative consequences for the economy. First and foremost, in buying JGBs the BOJ purchased more than half of all bonds issued in the country, which significantly reduced their liquidity.
The newly-installed Governor Ueda announced his decision to terminate YCC almost immediately upon taking office after years of speculation. Both imported inflation and a spike in wages, unprecedented for decades, influenced the new governor's decision to terminate "unwinding operations"—recall that core inflation in Japan remained persistently above the 2% threshold and several large firms pledged to raise wages by more than 5% this year. Governor Ueda believes it is time to loosen his grip on the market and allow it to regulate itself.
The Domestic Picture
Japan was largely insulated from inflationary pressures emanating from abroad—and the local economy was doing just fine. With corporate profits reaching record highs, joblessness falling to a historic low, and overall economic health solid, the BOJ had little reason to rush in trying to curb inflation. What the monetary authority was desperately trying to avoid was the imported inflation spillover from overseas turning into something much worse.
High corporate profits have always been a major driver of Japan's equity markets—and the recent uptick in wages may well provide the much-needed boost to propel the Nikkei into new heights. Meanwhile, Japanese consumers are feeling the effects of inflation on a day-to-day basis—and the BOJ is caught between its dual mandate of curbing prices and stimulating the recovery, which it does by buying government bonds. The recent decision to unwind YCC was prompted by concerns about the detriments of near-zero rates and an accompanying need to return the monetary policy to normal.
Markets' Reactions
The decision to end the YCC resulted in the yen rising against the dollar—and the 10-year JGB yields climbed, albeit moderately, from the 0% "floor". When the BOJ announced its decision to unwind YCC—with all its subsequent implications—the markets were flooded with mixed signals. On the one hand, the shares of Japan's listed firms saw modest gains on the prospect of higher wages. On the other hand, exporters were concerned about the currency's rapid appreciation against the dollar.
At the same time, foreign investors' attention was fixed on the BOJ's decision to tighten monetary policy. Local pension funds and insurers had previously bought foreign bonds in search of higher yields, since the domestic bonds offered little value. With a growing number of local investors now considering opportunities in their domestic bond market, the ones abroad may soon feel the effects of this shift and experience lower demand for their securities.
A Careful, Not a Clean, Exit
Despite the markets' reaction to the BOJ's decision, the Bank of Japan has continued buying government-backed securities at the same breakneck pace. The BOJ has left the option of intervening in the markets open, when long-dated yields rise—thus signifying that the unwinding of YCC will be anything but orderly. Simply put, the BOJ does not have the luxury of aggressive tightening due to the crippling public debt, which exceeds 250% of the country's GDP. For the BOJ, Japan's debt-to-GDP ratio is a fiscal burden that cannot be ignored—and the new governor has little appetite for fueling inflationary pressures and exacerbating this burden.
The end of the YCC certainly marks the end of an era for the BOJ. Having loosened monetary policy for the last time, it may well move on to other measures aimed at slowing the rate of growth. Nevertheless, it is too soon to declare the BOJ's victory over inflation—with the outlook for wages remaining optimistic for 2024, it would be best to wait for further instructions from Governor Ueda before declaring the battle over.