The transformation of Japan’s economy from secular stagnation and deflation to reflation and sustained growth keeps gathering momentum in ways that continue to surprise investors. A key milestone to watch in this ongoing transformation is the gradual normalisation of monetary policy. Specifically, today’s reflationary backdrop appears to remove the rationale for the Bank of Japan (BOJ) capping long-term interest rates through its yield curve control (YCC) policy, and the central bank’s latest adjustments suggest that the policy, in place since 2016, is indeed on its way out. Is the next step a rate rise, and could it come sooner than markets currently expect?

Continuing the move away from YCC

The BOJ implemented YCC as a means of countering Japan’s persistent deflation, purchasing Japanese government bonds (JGBs) to control long-term interest rates. After July’s decision to allow yields on 10-year JGBs to reach 1%, officials moved further towards policy normalisation at the end of October by making the 1% yield limit a “reference” rather than a cap and, in effect, allowing yields to rise above 1%.

As a consequence, yields on 10-year JGBs briefly climbed above 0.9%, continuing the steady increase seen since July’s policy adjustment (Figure 1).

Figure 1

This doesn’t tighten monetary policy

The immediate objective of the BOJ’s latest YCC announcement was to signal to financial markets that policymakers want to avoid an abrupt sell-off in rates, preferring a gradual “managed” process that avoids a financial stability event.

Therefore, rather than monetary tightening, in our view, the YCC adjustments represent a move away from adding more monetary stimulus. The latest tweak is an adjustment to avoid the risk that the central bank is forced to accelerate its balance-sheet expansion, as policymakers have the option to intervene if yields change too quickly. If yields rise because the medium-term inflation outlook improves, the BOJ will no longer be tied to further monetary stimulus, which was previously the case. We anticipate further YCC adjustments in the first quarter of 2024 as the reflation theme continues to expand and improved economic growth potential becomes more embedded in market expectations.

What will policymakers do next?

The inflation outlook is undoubtedly shifting and, with the BOJ gradually buying into the sustainability of inflation, a rate hike is now in sight. Policymakers have revised up their core inflation forecasts for fiscal year 2024 from 1.9% to 2.8% and nudged up projections for fiscal year 2025 from 1.6% to 1.7%. If wages are shaping up to be at or above 2.5%, which we think is a likely scenario, inflation projections for 2025 will be revised upwards again and that, in our view, could be the trigger for a hike. This could happen as early as the first quarter of 2024, marking the formal exit from negative interest rates in Japan.

Bottom line

The bigger picture is that YCC adjustments are still very slow and subtle and Japanese monetary policy remains ultra-loose. Moreover, the Japanese government has announced more fiscal stimulus for the economy to help cushion the impact of rising prices, with a ¥17 trillion (US$113 billion) package that includes temporary tax cuts and rebates for households. While the BOJ may be stepping away from a stance that forced it to expand its balance sheet, the overall set of policies in Japan, when fiscal stimulus is considered too, is looser, not tighter, which may force the central bank to hike interest rates sooner than the market anticipates.