The Bank of Japan’s December Surprise – Economic Policy or Currency Politics?

In a surprise move that shocked markets, the Bank of Japan tweaked its yield curve control (YCC) policy by doubling the cap on bond yields from 0.25% to 0.5% at its latest policy meeting on December 20. 

As news of the BOJ move spreads across global markets, the unintended consequence was a sharp (albeit temporary) decline in equities and treasuries (treasury yields, which move in inverse of price, spiked briefly). This is because Japanese investors, who are one of the largest holders of US treasuries and foreign assets (including US equities), started liquidating their foreign holdings and repatriating funds back to Japan after hearing the news from the BOJ.

As a result of this situation, we should expect further shocks in the US treasury and the equity market each time the BOJ tweaks the yield curve at future policy meetings. But does this latest move signal a shift towards a more hawkish policy direction from the BOJ? Most likely not.

Did inflation or the yen drive this move?

Prior to the latest policy change, Japan was the only remaining G7 country that had not tightened monetary policy to rein in inflation. BOJ Governor Kuroda's argument against any departure from monetary easing has been similar to what the Fed was saying a year ago – "Inflation is transitory", and the BoJ had not seen enough evidence to negate the view that inflation was only temporary due to short-term energy hikes and supply chain disruptions.

Inflation in Japan has been significantly lower than all its G7 counterparts, and the BOJ had repeatedly made it clear that it would not begin tightening until there were signs of sustained wage increases, which is unlikely any time soon.

Some market commentators are of the view that the YCC adjustment is the first step from the BOJ on the road toward policy normalization. But personally, I believe that the BOJ won’t abandon YCC and may just tinker around at the edges. It’s possible the BOJ will continue to calibrate the yield caps here and there, but it will not increase the benchmark interest rate from the current -0.1% or start any major quantitative tightening programs until 2024. The Japanese economy is still vulnerable and would not be able to withstand any monetary policy tightening at this stage. 

Governor Kuroda has been emphatic that last month's move was not a departure from the current easing policy, defending the move by claiming it was intended to "improve market functioning.” I believe that last month's move had little to do with fighting inflation in any meaningful way. The move probably did not have much to do with "improving market functioning" either, with a lack of catalysts to support the timing of the policy change.

However, the depreciation of the yen throughout 2022 (due in part to more hawkish policies at the Fed and other central banks) has been politically damaging to prime minister Kishida's government and has been labeled as one of the main reasons why inflation has been creeping into Japan. In my opinion, the BOJ and Kuroda have been pressured by the Ministry of Finance and the Japanese government into taking action to arrest the yen’s decline.

The surprise move did cause a surge in the yen, but we could anticipate the yen will gradually go back to previous levels as the Fed continues to tighten aggressively, and when it becomes apparent that the BOJ's move last month was just a flash in the pan (i.e., not part of any sustained effort to fight inflation). 

Kuroda has been roundly criticized for the shock announcement last month. Given that he has only three months left in his term, the move left many wondering why he did this now. But Kuroda is known for making surprise moves when the market is least expecting it. It is quite different from the choreography and continuous telegraphing in advance by Jay Powell at the Fed regarding upcoming policy changes. Kuroda's announcement, in contrast, appeared disjointed and lacking in any long-term strategy. 

The BOJ's credibility has been shaken by this latest move. It has now invited speculators to enter the rates market and test the new 0.5% cap. Many are now placing bets that the cap will soon be increased once again to 0.8% - despite Kuroda's insistence that this was a one-off move with the intention of "improving market functioning.” It is hard to see how such trades fulfill the intention of improved market conditions. Meanwhile, the yen will, and should, remain in focus for investors heading into 2023.