BoJ’s cautious take on tightening to continue

The Bank of Japan has consistently sent the message that its monetary policy normalization will be cautious and data dependent. This makes it unlikely that the BoJ's policy board will decide to raise interest rates and begin reducing government bond purchases at the same meeting

Takatoshi Ito 3 Jul 2024

Last month, the Bank of Japan (BoJ) held its benchmark interest rate steady, but signalled that it will soon begin to scale back its government bond purchases, with the details set to be worked out at the policy board’s July 30-31 meeting. The BoJ promises that markets won’t be blindsided by the pace of the reduction, because policymakers plan to survey market participants about their expectations. But the pace of quantitative tightening (QT) – and how the reduction in purchases will affect bond yields – remains to be seen.

The current pace of purchases is keeping the BoJ’s balance sheet stable: each month, the central bank purchases about 6 trillion yen (US$37 billion) in bonds, which is roughly the same amount of its bond holdings that mature. According to my calculations, if the BoJ purchased no new government bonds from August 2024 through July 2025, it would shed, by maturity alone, 72 trillion yen worth of bond holdings – 12.4% of the total. This is a case of 100% runoff.

A second year of 100% runoff – August 2025 to July 2026 – would shave another 70 trillion yen off the BoJ’s holdings. In other words, in the space of two years, the BoJ would reduce its total government-bond holdings by one-quarter, without selling a single bond. This is probably much too sharp a decline – long-term bond rates would rise sharply, undermining capital expenditures and housing investment – so the BoJ is more likely to announce, say, a 50% runoff. It should also reserve the right to deviate from any official schedule, in response to long-term-bond-market volatility.

Beyond QT, BoJ governor Kazuo Ueda says that he has not ruled out raising interest rates as early as this month. This would be the second rate hike since Japan began its monetary-policy normalization. In March, it ended its negative interest-rate policy, setting the policy rate between 0.0% and 0.1%, and abandoned yield-curve control, which had been introduced to keep the 10-year government bond yield around 0%.

There was no negative market reaction to these moves, and the BoJ appears committed to ensuring the same result next time. It has consistently communicated to investors that the normalization process will be slow and data-dependent. Given this, it seems unlikely that the BoJ will launch QT and raise the policy rate in the same meeting.

To be sure, a hike this month is not impossible. If very strong economic signals – such as an increase in the underlying inflation rate, a large upward GDP revision, real wages turning positive or a surge in household spending – emerge before the policy board meeting, the BoJ might decide that it can raise rates without spooking markets. But such data are unlikely to materialize.

For starters, there is no sign of a resurgence in underlying inflation. Since peaking at 4.3% in July-August 2023, the “core-core” inflation rate – which tracks the prices consumers pay for a basket of goods, excluding fresh food and energy – has fallen to just 2.1% (as of May 2024). Though inflation has been running above 2% for the last two years, forecasters expect it to average just 1.83% in April 2025-March 2026.

Moreover, despite relatively robust GDP growth (1.9%) last year, the annualized quarterly growth rate has been negative in two of the last three quarters. While Japan’s wage and consumption prospects are brighter – the 5% wage increases promised during the 2024 “spring offensive” (pay-raise season) outpaced inflation, and consumption is likely to rise as a result – the shift will take hold over the next few months, not the next few weeks.

There is one other factor that market participants believe could spur the BoJ to hike rates soon: further yen depreciation. When the US Federal Reserve began raising interest rates aggressively in 2022 to rein in surging inflation, the BoJ held rates steady. The widening interest rate gap put downward pressure on the yen, forcing the finance ministry to intervene repeatedly to prop up the currency, which has nonetheless remained weak.

Traditionally, a weak yen is considered to be good for aggregate demand, stimulating exports and leading to positive spillovers. But export volumes have not risen in Japan for the past two years. Meanwhile, Japanese households are facing higher prices for imported consumption goods and locally produced goods that depend on imports. Some now argue that the BoJ should raise rates as soon as possible.

But the BoJ’s critics tend to ignore the risks raised by hasty interest rate hikes – not least the possibility of a recession and higher unemployment. More fundamentally, the BoJ maintains that currency stability is not part of its mandate, so it must act only when yen deprecation disrupts price stability. That is unlikely to happen by its next meeting. In any case, QT alone might be enough to stem the yen’s decline as the reduction in the BoJ’s balance sheet raises the long-term interest rate and steepens the yield curve.

The BoJ has signalled that it will take a cautious approach to monetary tightening, and so far it has followed through. This is unlikely to change any time soon.

Takatoshi Ito is a professor at the School of International and Public Affairs at Columbia University, a senior professor at the National Graduate Institute for Policy Studies in Tokyo, and a former Japanese deputy vice-minister of finance.

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