The recent decision by the Bank of Japan to raise interest rates marks the end of a 25-year era of providing virtually zero-cost rate funding to Japan and the world. Governor Kazuo Ueda’s move signifies the departure from financial socialism and the conclusion of an extended period of ‘capitalism with a zero-cost rate anchor’.
The decision to raise rates was prompted by a proactive approach to prevent future aggressive rate hikes and allow markets to adjust to Japan’s changing realities. Delaying the rate increase would have posed a greater risk of requiring more aggressive rate adjustments in the future. Governor Ueda aims to avoid reactive radicalism in favor of proactive gradualism.
One important aspect of this rate hike is its potential impact on inflation. Recent developments in Japan’s inflation risk profile suggest a shift towards possibly higher inflation rates than previously anticipated. The rise in wages could potentially lead to a demand-pull inflation spiral, with implications for domestic consumption.
While the wage increase bodes well for domestic consumption, it presents challenges for the Bank of Japan, as it has minimal control over the labor market and wage inflation. The tightening labor market and skills mismatch may exacerbate the situation, raising concerns about the potential impacts on the economy.
As Japan transitions from an era dominated by emergency central bank actions to combat deflation, there is a need for a re-evaluation of monetary policy priorities. Governor Ueda’s approach emphasises the importance of gradually reining in inflation, marking a departure from the previous focus on escaping deflation.
Looking ahead, Governor Ueda is expected to maintain negative real policy rates, providing support for yen-risk assets, such as equities, real estate, and non-yen securities. This approach aims to guide the economy towards a new normal and away from years of emergency measures that suppressed market dynamics.
The shift in focus from deflation to inflation has raised questions about Japan’s monetary policy priorities. After decades of missed inflation targets, achieving and anchoring inflation expectations remains a daunting task for the Bank of Japan. As the central bank begins the journey of normalisation, it faces uncertainties regarding the optimal interest rate level and policy rate anchor.
On the capital markets front, Japan’s corporate landscape is witnessing unprecedented corporate actions driven by a need to put ‘lazy balance sheets’ to work. Record business investment spending, increases in dividend hikes and share buybacks, as well as a surge in mergers and acquisitions, indicate a positive momentum in the capital markets. The termination of financial socialism by the Bank of Japan is expected to promote further efficiency in the market, with less productive companies forced to restructure or make way for more efficient players.
In conclusion, the decision by the Bank of Japan to end financial socialism and market intervention is a significant step towards restoring confidence in the economy and endorsing the return of capitalism in Japan. An upcoming roundtable will provide the opportunity to explore the economic outlook for Japan in greater detail.