The Bank of Japan (BOJ) Monetary Policy, Fully Explained

Japan has begun to shift away from the low interest rate policy it has kept for the past 10 years. Because of this, countries around the world, including the US and Europe, are closely watching the moves of the Bank of Japan (BOJ). So what exactly is going on?

Japan's 10-Year Low Interest Rate Policy

Over the past 10 years, Japan has been almost the only country in the world to keep a low interest rate policy. The US, Europe and South American countries, thrown into panic by high inflation, have recently raised rates aggressively to tame it. Japan, however, has calmly kept its negative rate of -0.1%.

Why does Japan keep its low interest rate policy? It's because Japan has an export-driven economy. In other words, a weak yen is good for its domestic economy. Japan has also been going through an economic slump for quite a long time. Raising rates would dampen business and household activity. To sum up, here's why Japan has kept its low interest rate policy: inflation is not that high compared with other countries right now, and because of the slump, it's not easy to raise rates even if it wanted to.

A Shift in the Low Interest Rate Policy

Yet at its last monetary policy meeting, that same Japan raised the target range for the 10-year long-term rate to ±0.5%. It was a signal to the market that change had begun in the low interest rate policy it had held for so long.

It would be a mistake to see a change in Japan's rate policy as being on the same level as a change in Korea's rate policy. Japan is a country whose economic ripple effects are nearly as large as those of the US. For example, Japan is the largest holder of US Treasuries. Are you starting to get a sense of why you should pay attention to Japan's policy changes?

If Japan ends its long-running low interest rate policy, investors who used yen to invest in all kinds of assets will try to sell them and pull their money back. Imagine the people who hold the most US bonds in the world starting to sell. A broad market decline could begin.

A Breather: The Yen Carry Trade Unwind

However, at its recent monetary policy meeting, Japan did not immediately raise short-term rates. It kept them frozen at the existing -0.1%. It also decided to keep the long-term rate, the 10-year government bond yield, at around ±0.5%. Japan saw that the market reacted more sensitively than expected, and at a more fundamental level, it was worried that raising rates would send its own economy into a slump.

As a result, there was no major yen carry trade unwind this time. The yen carry trade is a trading strategy where you borrow a low-interest currency like the Japanese yen (¥) and invest in another, higher-interest currency. If the value of the undervalued yen rises, investors will try to sell their assets and pay the yen back. That is what's called a yen carry trade unwind.

Where YCC Goes Next Is Worth Watching

We may have caught a breather, but it's worth keeping a close eye on Japan's rate policy going forward. As I briefly mentioned earlier, Japan has recently been making gradual changes to YCC (Yield Curve Control). YCC is a policy in which the Japanese government directly holds the 10-year government bond yield at 0% to keep the yen weak. In other words, YCC means actively stepping into the market and buying bonds. But right now, the allowed yield fluctuation band has been raised to around ±0.5%. By adjusting YCC, Japan has signaled that it is moving away from its long-standing weak-yen stance.

Wrapping Up

The Bank of Japan, which has kept a low interest rate policy for the past 10 years, is showing signs of a policy shift. If Japan ends its low interest rate policy aimed at a weak yen, government bond yields will rise. Bond prices will fall, and a yen carry trade unwind, which triggers mass selling across many investment assets, could follow. Since Japan has a huge influence on global asset markets, it's worth continuing to closely watch the policy moves of the Bank of Japan (BOJ) as it shifts away from its low-rate yen stance.