News in Charts: Japan’s ongoing structural departure from QQE

The Bank of Japan raised interest rates on 31 July 2024 from 0% to 0.25%. This was a further uptick from the rate hike in March 2024, when the policy rate was increased for the first time in 17 years: rising from -0.1% to 0% and ending eight years of negative interest rates. The March move signalled a structural departure from the quantitative and qualitative easing (QQE) monetary policy regime introduced in April 2013 by the bank’s former governor, Haruhiko Kuroda. But recent market volatility following the latest rate hike begs the question — is the BoJ right to end its policy of extreme monetary easing, or will the exit prove premature?

Japan’s radical version of quantitative easing under Mr Kuroda became a long-term policy framework, intended to provide stimulus and overcome deflation. Yet inflation remained ultra-low for years, until eventually the heightened global inflationary environment after the COVID-19 pandemic and the Russia-Ukraine war hoisted Japan’s rate of inflation with it. Higher inflation also resulted in a hiking of policy rates worldwide, with Japan the last outpost of negative rates. Mr Kuroda’s successor, Kazuo Ueda, responded by rethinking the bank’s monetary policy regime and abolishing the negative-rate environment. The move was a bold one as low Japanese rates had become a baked-in structural assumption for markets, particularly in the global carry trade in interest-rate differentials. This structural reconfiguration of Japanese monetary policy, and the subsequent volatility in the yen, has underpinned the recent global market turmoil.

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QQE was aimed at overcoming entrenched deflation by rapidly expanding the money supply. This was attempted by increasing the bank’s balance sheet through purchases of Japanese government bonds (JGBs) and qualitative improvements from the acquisition of exchange-traded funds (ETFs) and Japanese real estate investment trusts (J-REITs). The Bank of Japan hoped QQE would influence risk-premia as well as double the monetary base in two years — from 138 trillion yen at the end of 2012 to 270 trillion yen at the end of 2014. The increase in the monetary base was achieved, but without a noticeable uptick in inflation.

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Since 2016, the Bank of Japan started using QQE with yield curve control (YCC), yet another exotic monetary policy tool. Under YCC, the bank determined the interest rate for different maturities of government bonds and then bought or sold the bonds required to reach the target rate.

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So from 2016 until the start of the pandemic, in light of the prolonged ultra-low interest-rate environment, the bank allowed for JGBs to be purchased on a flexible basis — lowering or increasing the JGBs purchased as required — in order to maintain the yield of 10-year JGBs at around 0%. YCC significantly influenced the volume and frequency of purchases of Japanese Government Bonds (JGBs) by the Bank of Japan.

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Japan’s inflationary environment is normalising after a long period of deflation, and the monetary policy regime has therefore become more conventional under Mr Ueda. The Bank of Japan is more focused on keeping inflation close to its 2% target. Mr Ueda said in a lecture on 8 May that it was now within sight and that the price stability target would be achieved in a sustainable and stable manner. The Bank of Japan’s view was that the large-scale, long-term monetary easing under QQE had therefore fulfilled its role. Against this backdrop, the year-on-year rate of increase in the consumer price index (CPI) excluding fresh food is at 2.8%. Private consumption was also expected to gradually return to an increasing trend.

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While inflation has now been above 2% for over two years, there are some signs that the nature of this inflation has changed. The initial rise in inflation, which could be attributed to cost-push pressures (including rising energy prices), is now gradually dissipating as the upward pressure on import prices ceases. In contrast, wage-price dynamics may raise inflation in a more sustainable manner as firms adjust their wage and price-setting behaviour. In this context, recent price developments have shown that the rate of increase in the prices of goods, especially food products, has clearly been falling, which shows that the effects of the cost-push pressures are easing. However, on the other hand, prices in services, for which labour costs are key, have continued to rise moderately. This suggests that the effects of wage-price dynamics are increasing.

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As of now, it is not clear whether economic conditions warrant policy tightening, and recent moves may seem more targeted at preventing further yen weakness. It remains to be seen whether 2% inflation will be achieved in a sustainable way (whether it does will depend on whether wage growth continues to firm). For now, the bank has announced that it will make no more ETF or J-REIT purchases, but JGB purchases will broadly remain the same.

Mr Ueda also flagged in his speech that despite the improved economic outlook, future developments in foreign exchange rates and international commodity prices present a risk, in particular in the degree to which they will translate into import price rises. The governor believes that financial markets will continue to drive the interest rate somewhat, through the carry trade. But in light of this week’s global market developments, the Bank of Japan has said it will hold rates steady if the volatility continues.

The views expressed in this article are the views of the author, not necessarily those of LSEG.