Bank of Japan tweaks ultra-loose monetary policy

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The Bank of Japan has injected “greater flexibility” into a cornerstone of its ultra-loose monetary policy, prompting a surge in government bond yields.

The central bank said it would continue to cap the yield on 10-year Japanese government bonds at 0.5 per cent but would allow long-term interest rates to rise above that level without setting “rigid limits”.

The BoJ also said it would offer to buy 10-year JGBs at 1 per cent in fixed-rate operations, instead of the previous 0.5 per cent.

While the BoJ amended its seven-year strategy of buying bonds to depress yields, known as yield curve control, it kept overnight interest rates on hold at minus 0.1 per cent, saying more time was needed for it to sustainably achieve its 2 per cent inflation target.

Japan is the only country in the world with negative interest rates, and any reversal of this strategy would have sweeping implications for global financial markets.

“Strictly capping long-term interest rates could affect the functioning of the bond markets and the volatility in other financial markets. Such effects are expected to be mitigated by conducting yield curve control with greater flexibility,” the BoJ said in a statement on Friday at the conclusion of a two-day board meeting.

The 10-year JGB yield rose to a high of 0.541 per cent following the BoJ announcement. The yield had breached the 0.5 per cent yield cap for the first time in four months earlier in the day, following a media report that the central bank would adjust its policy.

Japan’s yen, which had strengthened against the dollar in morning trading, briefly fell as much as 1.1 per cent before reversing course to be up 0.6 per cent at ¥138.66. The benchmark Topix stock index was down 0.8 per cent, but a banking sub-index rose 4.4 per cent.

Benjamin Shatil, FX strategist at JPMorgan in Tokyo, said that while the change to the YCC was relatively small, it represented a “giant leap” for BoJ policy.

“Rightly or wrongly, market participants will conclude that this marks the beginning of the end for YCC,” he said. “The immediate implication is that the BoJ has allowed for more flexibility in domestic yields; but whether this also translates into a risk of higher market volatility will need to be closely watched.”

BoJ watchers also warned that loosening the cap on bond yields without setting a specific ceiling would invite investors to test the bank’s resolve and could cause sharp rises in 10-year JGB yields and fluctuations in other markets.

When the central bank last altered its yield curve control policy in December — widening the band to half a percentage point, from a quarter — government bond prices slid and yields surged to the highest level in two decades.

“The overall direction of bringing more flexibility to the YCC framework is correct, but it does raise questions on how much the BoJ will tolerate, and it’s inevitable such a move would invite prodding from the markets,” said Mari Iwashita, chief market economist at Daiwa Securities.

As other leading central banks including the US Federal Reserve and the European Central Bank continue to raise rates, the future of the BoJ’s ultra-loose policy stance has come under intense investor scrutiny.

The Japanese central bank’s accommodative policy has also been challenged by price rises that have proven more widespread and resilient than anticipated.

Headline inflation in Japan rose to 3.3 per cent in June, outpacing the US figure for the first time in eight years. On Friday, the BoJ raised its core inflation forecast for the 2023 fiscal year from 1.8 per cent to 2.5 per cent.

Additional reporting by Will Langley in Hong Kong