To help interpret the policy shift by the Central Bank, one needs to understand the history of the Japanese economy over the past 30 years and the measures introduced by their Central Bank in response to it.

The collapse of Japan’s asset price bubble in the early 1990s was a watershed event that had a lasting impact on domestic policymaking. Prior to the collapse, the Japanese economy had  been growing at a healthy pace and inflation had been low and stable. Nevertheless, financial imbalances were gradually building up, with equity and real estate prices reaching unprecedented levels in the late 1980s and early 1990s. When the asset bubble eventually burst, the ensuing financial crisis and its broad-based impact on economic activity triggered a intense policy debate on how to strengthen policy institutions and financial market regulation.

In the late 1990s and early 2000s the Japanese economy was facing slowing demand, declining consumer prices, and financial instability due to a confluence of factors, including the 1997 consumption tax hike, a domestic banking crisis, and the Asian Financial Crisis. Unfortunately, with the policy rate already close to zero, the BoJ was severely constrained in providing monetary policy support. Hence, in the absence of conventional policy space, the BoJ embarked on a number of unconventional policy measures.

At a high level, these unconventional policy measures introduced by the BoJ included:

• The introduction of a Zero Interest Rate Policy (ZIRP) in February of 1999 where interest rates were kept ‘as low as possible”.
• A new policy initiative labelled Quantitative Easing Policy (QEP) was introduced in early 2001. The new policy was a shift from the BoJ targeting interest rates to the targeting quantity of reserves and purchases of government bonds to increase the monetary base.
• The BoJ began buying risky assets such as exchange-traded funds (ETF) and real estate trust funds (REIT) in 2010. Unlike government bonds, ETFs do not have maturity and therefore won’t fall off the BoJ’s balance sheet unless the central bank sells them in markets to a third party.
• The introduction of a Negative Interest Rate Policy (NIRP) in early 2016.
• The BoJ introduced a new operational framework labelled Yield Curve Control (YCC) in response to the side effects of NIRP where the yield curve flattened more than anticipated. The objective of YCC was to shape the yield curve by targeting both the short-term interest rate and the long-term interest rate by purchasing government bonds along the entire yield curve. The BoJ had set a 0% target and a loose ceiling of 1% for the 10-year government bond yield under yield curve control to prevent excessive falls that flatten the yield curve and crush investors’ margins.

How has Policy shifted?

Each year in March, management of major Japanese firms meet with unions for wage talks across industries that set the tone for employees’ pay in the new fiscal year. This is known as Shunto (spring wage offensive). The Shunto announcement in March revealed a 5.9% average wage increase, the largest increase since 1993. This sharp increase in wages was enough of a shock to prompt the BoJ to make significant policy decisions.  See Figure 1.

Figure 1

The changes included:

Lifting the target range on its main policy interest rate by 10bps to 0-0.1%. Although the increase is ‘relatively’ small, the move lifts interest rates out of 7 years of negative rates to around zero and marks the first increase in 17 years.

Ending the Yield Curve Control (YCC) program that capped the level of 10-year Japanese government bonds through BoJ purchases. The central bank dismantled YCC by removing the target and the reference. But it inserted a guidance in the policy statement pledging to keep buying roughly the same amount of bonds as before, and intervene with bigger purchases if bond yields rise rapidly.

Formally stopping purchases of ETFs and REITs, while looking to discontinue corporate bond buying within one year.

Despite a move away from an extremely accommodative monetary policy (hawkish move), the market interpretation was dovish. The yield on government bonds dropped and the yen weakened by around 1.5% against the dollar. See Figure 2. The likely cause of the dovish market reaction was due to the lack of forward guidance from the BoJ in terms of timing of future rate hikes. The BoJ also sited that conditions would remain accommodative for some time. As Japan moves out of the era of negative rates it will be interesting to see how their Central Bank adjust policy in reaction to economic conditions.

Figure 2