How high will the BoJ go after ditching negative interest rates?

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Policymakers at the Bank of Japan are tackling a series of thorny policy debates as they confront the practicalities of raising interest rates for the first time since the summer of 2006.

While Japan’s central bank has signalled that it is almost ready to end an unprecedented era of cheap money, with the first rate increase expected as early as March or April, it still faces a number of challenging decisions about how to leave negative rates behind without causing turmoil for global markets and Japanese lenders.

Among those questions is whether to raise rates first to zero or directly into positive territory; what to do about the central bank’s vast bond portfolio; and most important of all, what to signal about the path of interest rates beyond the first increase.

“The BoJ hasn’t shown its hand in terms of the really fine details,” said Takafumi Yamawaki, JPMorgan’s head of Japan rates research. “It has said it wants continuity, but whether that only applies to the policy rate or elsewhere is difficult to tell.”

On the first issue, BoJ officials are close to a decision: they are likely to raise the policy rate by 20 basis points to 0.1 per cent. In a recent speech, BoJ deputy governor Shinichi Uchida suggested this would cause money market rates to rise from a bit below zero to a range of between zero and 0.1 per cent.

That still leaves a tricky question of whether to abandon the BoJ’s complicated three-tier system of interest rates for deposits with the central bank, which it adopted eight years ago in order to encourage trading on interbank markets and limit the hit to bank earnings from its negative interest rate policy.

“The most obvious route would be to do away with the tiering,” said Stefan Angrick, a senior economist at Moody’s Analytics. “The Bank of Japan has had a zero-interest rate policy and it didn’t have a tiering system at the time so it’s perfectly logical.” 

But returning to the situation before 2016 will not be easy, according to Izuru Kato, a longtime BoJ watcher and chief economist at Totan Research. If the tiering system is removed, there will be few incentives for banks to trade in short-term money markets unless the BoJ starts to shrink its balance sheet to reduce its excess reserves.

Kato said the BoJ could keep a two-tier system to prevent a fall-off in interbank trading, pointing to how the Swiss central bank maintained its reserve tiering for the same reason after returning to a positive policy rate in 2022.

In its bond portfolio, the BoJ is unlikely to make any bold shift towards quantitative tightening — suspending asset purchases or even selling assets. Instead, officials think they can take advantage of an uneven maturity schedule to wind down the portfolio slowly even as they keep buying new bonds.

Annual maturities from the portfolio will run at about ¥70tn ($470bn) during the next few years. With the BoJ buying bonds at barely that pace, small adjustments to the purchase schedule could tip the portfolio into decline.

Aside from the technical decisions, what is clear is that the BoJ’s path to policy normalisation will be different from those taken by the US Federal Reserve and the European Central Bank when they carried out a series of rate rises in 2022 to bring down inflation.

Japan’s economy grew just 0.1 per cent on a quarterly basis during the final three months of 2023 due to weak consumption, while a recent period of sharp price rises — which policymakers welcomed after years of deflation — appears to be already coming to an end. Core inflation slowed in January for the third straight month, holding steady at the BoJ’s 2 per cent target.

That means rates are likely to stay very low for the foreseeable future, and BoJ officials do not see the first rise as a signal that more will quickly follow.

In his speech, Uchida stressed that Japan’s situation could not be compared with those in the US or Europe since inflation expectations have yet to be anchored at 2 per cent following a long period of deflation and economic stagnation.

“Even if the Bank were to terminate the negative interest rate policy, it is hard to imagine a path in which it would then keep raising the interest rate rapidly,” he said.

Markets players are still divided on how gradual the pace of rises will be. Yamawaki and UBS expect the policy rate to stay at zero or 0.1 per cent until 2025, while Morgan Stanley anticipates it rising to 0.25 per cent by July.

The IMF has recommended the BoJ raise its policy rate over the next few years after scrapping its policy of capping the yields of 10-year Japanese government bonds and ending its quantitative and qualitative easing measures. But it added that the process should be gradual. 

“We agree with the Bank of Japan that there remains considerable uncertainty in terms of the inflation path,” Gita Gopinath, the first deputy managing director of the IMF, said at a recent news conference in Tokyo. “Given the history of deflationary pressures, I think it is right to be cautious.” 

One of the biggest uncertain factors is wage growth pressure. Large Japanese companies have signalled that they will raise wages in this year’s annual spring negotiations, which are due to conclude later this month.

But Kazuo Momma, former head of monetary policy at the BoJ who is now executive economist at Mizuho Research Institute, said stronger pay rises among small and medium-sized enterprises were needed to justify a second policy rate increase. 

According to Momma, if inflation eases and real wages rise, household consumption could start picking up later this year. “If that happens, then there might be one more rate hike by the end of the year.”