Why Japan’s Sudden Shift on Bond Purchases Dealt a Global Jolt

Japan is the world’s largest creditor. At the end of 2021, it held roughly $3.2 trillion in foreign assets, 30 percent more than No. 2 Germany. As of October, it owned over a trillion dollars of U.S. government debt, more than China. Japanese banks are the world’s largest cross-border lenders, with nearly $4.8 trillion in claims in other countries.

Late last month, the world got an unexpected reminder of how integral Japan is to the global economy, when the country’s central bank unexpectedly announced that it was adjusting its stance on bond purchases.

To those unversed in the intricacies of monetary policy, the significance of Japan’s decision to raise the ceiling on its 10-year bond yields may not have been immediately clear. But for the finance industry, the surprising change raised expectations that the days of rock-bottom Japanese interest rates could be numbered — potentially further squeezing global credit markets that were already tightening as the world economy slows.

Since this summer, the Bank of Japan has been an outlier, keeping its interest rates ultralow even as other central banks raced to keep up with the Federal Reserve, which has ratcheted up lending costs in an effort to tame high inflation.

As global rates have diverged from those in Japan, the value of the yen has fallen as investors sought better returns elsewhere. That has put pressure on the Bank of Japan to shift the world’s third-largest economy away from its decade-long commitment to cheap money, a policy known as monetary easing.

Japan’s deep integration into global financial networks means that there is a lot of money riding on the timing of any move away from that policy, and investors have spent years fruitlessly waiting for a sign.

As of mid-December, the overwhelming expectation was that the bank would hold off on any changes until next spring, when Haruhiko Kuroda, the Bank of Japan’s governor and an architect of its current policies, is set to step down.

So when the bank made its bond yield announcement, which effectively raised interest rates, it caught virtually everyone off guard.

Mr. Kuroda has been adamant that the decision does not represent a fundamental change in monetary policy. He has insisted that it was intended to encourage trading in 10-year bonds — the bank’s preferred tool for controlling interest rates — which had slowed to a trickle under the bank’s tight controls.

But markets, at least in the short term, weren’t convinced. After the announcement, global stock markets dropped. The yen surged more than 3 percent. And bond yields shot up.

No one, perhaps not even Mr. Kuroda, knows what the bank will do next, said Paul Sheard, a former chief economist of S&P Global. But among some market participants there’s a belief that “when a central bank makes one move, a lot more are coming,” he said.

For “the median investor in the world who’s looking at Japan out of the corner of their eye,” he said, “suddenly you see something that looks like the first move in what could be monetary tightening. That’s like a game changer.”

To understand why, we have to go all the way back to 2013, when Shinzo Abe, then a newly elected prime minister, proposed aggressive policies intended to shock Japan’s economy out of its decades-long torpor.

The most important piece of his strategy was a monetary policy intended to make it easier and more attractive for companies and households to borrow money and spend it.

Among other things, Mr. Abe and his team aimed to push inflation up to 2 percent. Japanese prices had languished for decades: The cost of fried chicken at one convenience store chain hadn’t gone up since the 1980s. While that might seem good for consumers, economists argued that it inhibited companies’ growth, which, in turn, made them reluctant to raise wages.

A modest increase in inflation could break that stasis, they believed, creating a virtuous cycle of rising prices, increased corporate profits and higher wages.

The Bank of Japan told everyone who would listen that it would do whatever it took to achieve its goal of stable price increases. The message was clear: It’s better to spend now, while things are still cheap.

To prove it meant business, the bank started purchasing vast sums of equities and bonds, spending so much that it doubled the amount of currency in the economy in less than two years. (At its peak, in May of last year, it had grown over five times.)

Central banks following a conventional monetary policy tend to focus on controlling short-term interest rates and let markets determine long-term rates. But in 2016 — with inflation still dormant — Japan decided to attempt something very unusual: It would seek to directly control some longer-term rates as well, using an untested policy called “yield curve control.”

Financial institutions set their interest rates, whether on a bank loan or a corporate bond, based in part on the expected yields from government bonds. Reducing the market’s role in determining the prices of those bonds, the Bank of Japan figured, would let it better control lending conditions.

The mechanism for accomplishing that depended on one of a bond’s most fundamental attributes: Its price and yield move in opposite directions. The lifetime value of a bond is fixed on the day it’s issued, so if you pay more for it, your returns — the yield — go down. If you pay less, they go up.

When the Bank of Japan introduced its new policy, it committed to buying as many bonds as necessary at whatever price was required to keep yields around zero percent on the 10-year bond, the benchmark for other rates.

Things didn’t quite go as planned.

Rates stayed low, and inflation did, in recent months, hit the 2 percent benchmark. But it kept climbing, reaching 3.7 percent in November, a 40-year high. And most of that wasn’t the good, wage-boosting, demand-driven inflation the Bank of Japan wanted. It was “bad” inflation created by supply shortages from the pandemic and Russia’s war on Ukraine.

What’s more, the growing gap between interest rates in Japan and elsewhere was pushing down the yen’s value, piling even more stress on the country’s highly import-dependent economy. That made some analysts speculate that the Bank of Japan would soon be forced to raise interest rates.

Which brings us up to December, when Mr. Kuroda suddenly announced that the bank would double the ceiling on 10-year bond yields, allowing them to fluctuate between plus and minus 0.5 percent, and effectively raising interest rates.

To many investors, the decision seemed like the first tentative step toward even bigger rate increases. As bond yields have jumped, the bank has had to spend heavily to defend its rate target.

Which raises the question, how much longer can the Bank of Japan stick to its guns?

The answer depends on a number of factors, including the performance of the global economy and whether the central bank feels it has finally reached its targets for wage growth and inflation, said Toshitaka Sekine, a professor of economics at Hitotsubashi University.

Most experts believe that the process of unwinding Mr. Kuroda’s monetary easing policy, when it happens, will take years. It is certain to be complicated: Many Japanese borrowers have become accustomed to cheap money — variable interest rates are common, for example — and a hasty retreat could strain households and firms alike.

It could also be painful for global markets that have come to take Japan’s loose monetary policy for granted. Years of anemic growth and a decade of super-low interest rates have pushed many Japanese investors to seek higher returns abroad, increasing their already prominent role in global credit markets.

Although unlikely, a rapid reversal by the Bank of Japan “could generate some hard-to-anticipate shock waves around the world,” said Brad Setser, a fellow at the Council on Foreign Relations and an expert on global trade and capital flows. “In the worst-case scenario, rapid rises in long-term Japanese rates push up long-term interest rates globally.”