Japan’s extraordinarily expensive defence of its monetary policy

The Bank of Japan (boj), opened up speculators in December. By lifting its cap on ten-year government bond yields from 0.25% to 0.5%, the central bank raised the prospect that it would abandon its “yield-curve-control” policy entirely. The bond markets have become increasingly hostile to officials, putting them under increasing pressure. The boj has been forced to make enormous bond purchases in an attempt to drive down the yield, buying ¥9.5trn yen ($72bn) on January 12th and 13th alone.

Speculators excitedly awaited the boj’s next meeting. Was this the moment that the central bank would give up on the fight? The boj declared that it would continue to operate on January 18. The bank even stated that it would buy additional bonds if required. Short-sellers took their wounds and the yen plummeted on the news. But defending this policy is becoming extremely costly. The boj’s difficult decisions are not going away.

Yield-curve control was introduced by the bank in 2016 as part of an aggressive programme of monetary easing, which it hoped would lift Japan’s dormant inflation and economic growth. The boj is one of the few central banks to have stuck to its guns in 2022—neither raising interest rates nor halting large-scale asset purchases—as inflation has risen around the world.

However, the Japanese inflation rose to 4% annually in December. This is half of the peak levels in America and Europe. This surge can be attributed to the weak yen (which hit a 32 year low against the dollar in Oct) and high energy costs. According to the boj, underlying inflation has yet to reach its target of 2%.

The central bank’s decision to lift the cap on bond yields in December was an attempt to improve liquidity and facilitate more trading. It appears to have backfired. The boj owns around half of the country’s bond market, and more than 95% of some bond issuances, after a decade of hefty purchases. Market shortages have been exacerbated by additional purchases to protect the cap.

The boj’s decision to hold fast could exacerbate the situation. The central bank is causing huge losses to its bond portfolio. If Japanese bond yields were to rise by 0.25 percentage points, the bank’s total holdings as of January 10th would slump in value by around ¥7.5trn, or 1.4% of gdp, according to our calculations. The potential loss increases for every additional bond purchased to maintain the yield limit.

Higher yields also alter Japan’s fiscal arithmetic. The third quarter of last fiscal year saw the government’s net debt rise to 173% of gdp, which is the highest among rich countries. Interest payments account for around 8% of the nation’s budget. If payments on the stock of government debt rose by the same amount—0.25 percentage points—the total bill would run to ¥11trn, or 10% of this year’s government budget. The boj does not have any options for the year ahead.

© 2023 The Economist Newspaper Limited. All rights are reserved.

The Economist is licensed to publish this article. You can find the original content on https://www.economist.com/finance-and-economics/2023/01/18/japans-extraordinarily-expensive-defence-of-its-monetary-policy