What’s the Next Step for the Bank of Japan?

Passive quantitative tightening could be the Bank of Japan’s next step toward normalization. Here’s why.

In March, the Bank of Japan (BOJ) abolished its eight-year-old negative interest-rate policy, hiking rates for the first time in 17 years by raising its benchmark rate to 0%–0.1%. Though this move was long awaited, it’s only one step on the path of normalization. 

We think the BOJ should take their time progressing along that path. In our view, slow normalization of policy is best; the resulting low volatility, higher yields and steeper yield curve describe a friendly environment for bond investors. But what specifically is the ideal next step on the normalization path for the BOJ? 

Interest Payments May Constrain Further Rate Hikes

One possible next step for the BOJ would be to hike rates again. But that could result in a prohibitive increase in interest payments. 

We can determine how much of an increase is too much by calculating the breakeven rate for cash flow—that is, the highest interest rate at which the interest income from the BOJ’s excess reserves remains sufficient to cover the interest expenses on its liabilities. 

Given excess reserve deposits of ¥548 trillion, an interest rate of 10 basis points (bps)—the higher end of the latest rate hike range—generates an interest payment of ¥548 billion. Two possible break-even rates are 60 bp, based on fiscal year 2022 ordinary profits, and 80 bp, based on fiscal year 2023 ordinary profits. Interest payments at these levels would run ¥3.3 trillion to ¥4.4 trillion, respectively. Beyond this point, further rate hikes could be possible if the BOJ were to tap the reserve’s unrealized bond trading losses. 

But there’s another—and we think better—option for the next step toward normal.

First Things First: Passive Quantitative Tightening 

To combat inflation while also avoiding an excessive surge in interest payments, the BOJ is considering passive quantitative tightening (QT). With this approach, the central bank would shrink its balance sheet simply by allowing its holdings of Japanese government bonds (JGBs) to mature while limiting replacement purchases. By strategically shrinking the balance sheet first, the BOJ would reduce the size of its future interest payments, while reserving a 50 bp rate hike as an option for down the road, when—given a smaller balance sheet—interest payments would be less costly. 

Another benefit of this approach is that it buys time for the central bank to assess the effect of the initial rate hike on Japan’s economy. Japan’s natural interest rate, or r-star (r*), which defines the economy’s real potential growth rate, has likely risen—but by how much? The answer would help the BOJ refine its policy stance. 

Unfortunately, estimating r-star in real time is difficult anywhere, but it’s particularly tough in Japan, where short-term rates have hovered near zero for three decades and where the yen has weakened against other currencies. Under these conditions, time for taking stock of the situation is especially valuable. 

There are other benefits to taking a gradual, passive approach to QT as well. For one, the BOJ would avoid the potential disruption of financial markets that can come with selling assets—that is, it could help maintain low market volatility levels. Meanwhile, by reducing demand for bonds and signaling a less accommodative stance, the central bank would effectively engineer an increase in longer-term rates, steepening the yield curve. 

Refining the Bottom Line: Likely QT Targets

For these reasons, we expect the BOJ to begin to gradually reduce its purchases of JGBs as it monitors the market’s reaction. Japan’s Ministry of Finance indicates there is room to reduce the balance sheet by roughly ¥160 trillion. But at what pace?

Currently, the BOJ buys roughly ¥6 trillion of JGBs monthly to replace its redeemed holdings. By reducing this amount to around ¥3 trillion monthly, the balance sheet would shrink by ¥36 trillion annually. At this rate, it would take more than four years to reach a total target reduction of ¥160 trillion.

In our view, the BOJ is likely to focus its buyback reduction on the three- to five-year and five- to 10-year areas of the Japanese yield curve. That’s because bonds in these maturity ranges currently have the highest ratios of buybacks to issuance among JGBs (Display), so there’s room to cut.

If the BOJ does reduce buybacks for these maturities, the resulting reduced demand would likely steepen that part of the yield curve, as yields on these bonds would rise more than yields on other maturities. 

Focusing the reduction in these areas could also help correct a distortion that recently developed, when the 10-year forward 10-year yield—the expected yield on a 10-year bond issued 10 years from today—returned to levels predating aggressive quantitative easing while the five-year forward five-year yield did not (Display). In theory, the five-year forward five-year yield should correspond to today’s 10-year yield. 

Slow and Steady Wins the Race

To us, gradual, passive QT would be the BOJ’s ideal next step. The low volatility, higher yields and steeper yield curve that are likely to result would be good news for both the central bank and bond investors. That’s why, to our minds, a slow and steady approach to normalization makes sense.