By Noriyuki Suzuki,
The Bank of Japan on Tuesday effectively removed its yield cap in response to an unexpected surge in U.S. Treasury yields and entrenched cost-push inflation, sending its strongest signal yet that it is preparing to unwind monetary stimulus to come more into line with its global peers.
BOJ Governor Kazuo Ueda said the latest policy tweak is unlikely to cause 10-year government bond yields to rise sharply above the previously-set ceiling of 1.0 percent, and it is intended to pre-empt forex volatility and other risks that may materialize.
The Japanese central bank decided to allow 10-year Japanese government bond yields to rise above 1.0 percent, while retaining its overall framework that keeps borrowing costs low under the so-called yield curve control program. Rising U.S. Treasury yields are adding upward pressure on long-term interest rates in Japan.
While the BOJ has not budged in its more than a decade-long commitment to monetary easing, focus now shifts to how much long-term yields will be allowed to rise and when the central bank will do the more difficult job of ending negative rates when it believes stable inflation backed by wage growth is achieved.
The impact of the move to loosen its grip on yields may not be enough to strengthen the yen as desired by the BOJ, and pressure could mount on the central bank to do more, analysts say, given the pain higher import costs are causing.
What influence higher long-term yields will have on the broader Japanese economy remains uncertain, though they will increase debt servicing costs for Japan, which has a debt load that totals more than twice its gross domestic product.
"Yield curve control won't last forever because long-term yields should be determined by market forces," said Yuichi Kodama, chief economist at Meiji Yasuda Research Institute.
"What the BOJ is trying to do is to effectively scrap the cap and restore some normalcy to the bond market."
"The BOJ has been gradually paving the way for future steps, such as ending its commitment to guiding 10-year yields around zero percent. That would come while it carefully monitors yen moves and the prospect of wage growth," Kodama said.
The yield curve control program was launched in 2016 under Ueda's predecessor Haruhiko Kuroda, setting short-term interest rates at minus 0.1 percent and guiding 10-year yields to around zero percent.
To address the negative effects of yield-depressing interventions in the bond market, the BOJ has made minor changes over the years. In July, the policy board decided to allow 10-year yields to rise toward the maximum limit of 1.0 percent but redefined the level as the "upper bound" at the meeting that ended on Tuesday.
"We wanted to modify and make it more flexible before long-term rates are pegged to their allowed limit," Ueda said at a press conference after the meeting. The benchmark 10-year yield rose to near 1.0 percent Tuesday ahead of the BOJ decision.
Yoshimasa Maruyama, chief economist at SMBC Nikko Securities, said the BOJ sent a "clear message" that it will prevent long-term yields from surging because levels above 1.0 percent are not appropriate under the current macroeconomic conditions.
"We don't expect a further modification of yield curve control to ensure more flexibility before it starts to normalize policy in principle," Maruyama added.
A key factor to gauge the BOJ's confidence in achieving the kind of inflation it wants is the sustainability of wage growth.
Japan's inflation rate has remained elevated much longer than expected, due largely to higher energy and raw material import costs. Price rises have weighed on consumer sentiment as real wages have fallen.
Based on the latest projections, core consumer inflation will have remained above 2 percent for three straight years by fiscal 2024.
The BOJ will likely allow long-term yields to rise if they reflect economic fundamentals, rather than speculative moves. Sharp gains, however, could hurt the economy and increase debt-servicing costs for Japan, which has relied heavily on debt to meet its spending needs.
"Financial markets may test the BOJ's tolerance. That being the case, 10-year yields rising to as high as 1.25 percent can be justified," said Takahide Kiuchi, executive economist at Nomura Research Institute, who is a former BOJ board member.
The government has already raised its assumed long-term interest rate used to calculate debt-related costs to 1.5 percent for fiscal 2024, up from a record low 1.1 percent in the current year to next March.
The widening of the interest rate gap between Japan and the United States has sent the yen sharply lower against the dollar. The euro also hit a 16-year high versus the yen after the BOJ's decision, which came after the European Central Bank held off on another rate hike last week.
Yuji Saito, head of the foreign exchange department at Credit Agricole Corporate & Investment Bank in Tokyo, said 151.95 yen is seen as the next barrier for the dollar-yen pair.
"The BOJ would want to buy time until around January when it is expected to end its negative rate policy," Saito said, adding that a breach of the near-152 yen level will take it to 155 yen.
BOJ chief Ueda, an academic who served in the past as a BOJ board member, said the yen's weakness could mean people expect inflation to increase. If the yen continues to fall and pushes inflation significantly higher, this may warrant a policy change, he added.
After Russia's war on Ukraine sent crude oil and other raw material prices higher, there are serious concerns the Israel-Hamas war could spill over into a wider Middle East conflict and drive commodity prices up further.
"We can't rule out higher crude oil prices and a weaker yen, which would add inflationary pressures," said Hideo Kumano, executive chief economist at Dai-ichi Life Research Institute, adding that future unwinding of monetary easing is no easy task. "The BOJ would have no other choice but to be strategically vague."
(Peter Masheter contributed to this story.)
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