The Bank of Japan’s remarkable decade

On April 8, Haruhiko Kuroda stepped down after a decade as governor of the Bank of Japan – the longest governorship in the BOJ’s 142-year history.

When he was appointed, the Japanese economy’s main problem was deflation: inflation had been negative, on average, for 15 years, implying that the economy was chronically performing below its potential.

Moreover, many exporters were suffering from a soaring yen, which hit JPY 75 per $1 in October 2011, compared to JPY 124 per $1 in June 2007, just before the global financial crisis. From that starting point to now, Kuroda created an extraordinary legacy. After introducing unconventional monetary policies to provide massive economic stimulus, he used an inflation-targeting framework to guide and improve its scope.

As a result, Japan’s deflation ended, and economic activity picked up, with actual GDP exceeding potential growth and the unemployment rate falling very low before COVID-19 hit.

Loading the Quiver

Kuroda was an unusual choice to become governor because he was not a career BOJ insider, nor did he have experience in the banking side of the Ministry of Finance (which by that point had ceded regulatory power to Financial Services Agency).

In the middle of his term as the head of the Asian Development Bank, he got a call from Prime Minister Abe Shinz to become governor of the Bank of Japan. On becoming prime minister in December 2012, Abe was looking for someone who could think outside the box.

Determined to bring deflation to an end, he wanted the BOJ to adopt an inflation-targeting framework – the first of the “three arrows” comprising his economic agenda (popularly known as Abenomics). To tackle deflation and move the economy toward a 2% inflation target, he appointed Kuroda in March 2013.

By that April, Kuroda had already exceeded market expectations with his announcement of a large-scale assetpurchase program. In a statement, the BOJ declared that it would: “achieve the price stability target of 2% in terms of the year-on-year rate of change in the consumer price index (CPI) at the earliest possible time, with a time horizon of about two years. In order to do so, it will enter a new phase of monetary easing both in terms of quantity and quality. It will double the monetary base and the amounts outstanding of Japanese government bonds (JGBs) as well as exchangetraded funds (ETFs) in two years, and more than double the average remaining maturity of JGB purchases.”

With that announcement, the yen immediately depreciated, and stock prices rose sharply. Kuroda’s decadelong pursuit of 2% inflation through qualitative and quantitative easing (QQE) had begun.

Under Kuroda’s version of QQE, the BOJ sought to expand its balance sheet quickly to account for the expansive QE policies already implemented by the US Federal Reserve and other Western central banks.

Japanese QQE was playing catch-up to reverse yen appreciation and worsening deflation. It worked. The yen continued to fall, and inflation rose above zero on the back of robust economic growth. By March 2014, the headline inflation rate had increased above 1.5%, and the 2% goal appeared to be in striking distance.

But then economic growth started to falter – a problem that some observers attributed to the Abe government’s consumption-tax hike in April 2014. The oil price dropped sharply in the second half of 2014, which affected Japanese domestic prices.

Kuroda concluded later that year that additional stimulus was needed, and in October the BOJ announced additional QQE measures, increasing the amounts of annual government-bond purchases from JPY 50 trillion to JPY 80 trillion. In 2015, growth remained stagnant and the inflation rate fell back to almost zero, partly owing to declining energy prices.

Into the Depths

Kuroda needed another tool to stimulate the economy, and in January 2016, he introduced a negative interest-rate policy. While European central banks had already gone deeper into negative territory, this was unprecedented for the BOJ. Acknowledging as much, Kuroda and his team carefully designed the policy to limit losses from deposits held at the central bank. A charge of -0.1% would apply only to newly deposited excess reserves, while existing excess reserves (with a 0.1% interest rate) would be grandfathered.

Moreover, the new deposits with a -0.1% interest rate would be moved to a category with a 0.0% interest rate after several months. The idea was that while the negative interest rate would stimulate lending, the three-tier rate structure would contain the overall interest burden on commercial banks. In the event, the announcement of a negative policy rate came as a surprise, since the BOJ had not even hinted that it was considering such a move. The market reacted accordingly.

While the BOJ’s policy rate had effectively declined by only ten basis points, the market rate on ten-year bonds declined more sharply, and the yield curve (the difference between yields on short- and long-term bonds) flattened – even inverting on some days in 2016 and 2017, in what is generally seen as a precursor to a recession.

The flattening of the yield curve resulted in complaints from three Japanese megabanks, as well as many regional banks, that relied on the maturity yield spread to turn a profit. For the first time since becoming governor, Kuroda came under fire, with critics arguing that the blow to banking profits would destabilize the entire financial system.

Curve Control

Kuroda carried on. In September 2016, he adopted yet another unconventional policy tool: yield curve control (YCC), in which the central bank targets a specific maturity

and then buys, or sells, as many of those government bonds as necessary to keep yields within a designated range.

The point of YCC is to control both the long rate (the tenyear bond rate, in the BOJ’s case) and the overnight rate, which is the traditional policy rate. Under its new YCC framework, the BOJ’s original target for the ten-year rate was set at 0%, plus or minus ten basis points.

Looking back, it seems that the BOJ had three main reasons for adopting YCC.

First, it wanted to respond to the “financial destabilization” criticism, and YCC would ensure that the yield curve would not invert again.

Second, since the long-term rate is more important for housing and fixed investments, it made sense to try to control it directly, rather than influencing it indirectly via the short-term rate. Keeping the long-term rate low was viewed as critical for supporting economic recovery and achieving the 2% inflation target.

Third, by setting the ten-year rate band wide enough, the BOJ would not necessarily need to purchase long-term bonds, because it could rely on a market-signaling effect. Hence, by adopting YCC, the BOJ effectively switched from QE to a regime for targeting two interest rates, which in turn would allow for a smoother transition away from QE (“tapering”).

This is exactly what happened in the years thereafter. The BOJ increased the YCC target range to 20 basis points in July 2018, and then to 25 basis points in March 2021, without provoking much of a reaction from the market. It also gradually reduced the amount of bonds purchased without ever announcing a tapering – in what came to be known as “stealth tapering.”

Flexibility and Patience

In addition to YCC, Kuroda introduced another tool in September 2016. This was implicit in his statement that the BOJ’s inflation targeting would allow for “overshooting.” In academic discussions of the issue, it is almost unanimously understood that a 2% target does not mean hitting 2% yearon-year inflation every month.

Rather, the 2% should be taken as an average over the course of the business cycle, or as a medium-term target. It is natural for inflation to exceed 2% when economic activities are strong, and to fall short in a recession.

Since Japan’s inflation rate had been below 2% for so long (from the introduction of the target in January 2013 to the mention of overshooting in September 2016), Kuroda emphasized that he would be patient and continue with monetary-policy easing even if the inflation rate finally rose above 2%.

That eventually did happen in the second half of 2022; but it is worth remembering that Kuroda had pre-announced his intent six years earlier.

Academic discussions also generally recognize that while the central bank’s primary goal is to keep inflation near its target over the medium run, economic indicators such as employment and GDP are also important and should factor into policymakers’ assessments. While the Fed and a few other central banks have dual mandates that explicitly set inflation and employment objectives, others are subject to the same expectation more implicitly.

In the BOJ’s case, Article 2 of the Bank of Japan Act states that, “The Bank of Japan conducts currency and monetary control, aiming at achieving price stability, thereby contributing to the sound development of the national economy.” (Emphasis mine.) Most people would read that as a dual mandate, or what the academic literature calls “flexible inflation targeting.”

By 2019, overall activity in Japan’s real economy had become quite robust. The gap between potential and actual GDP had narrowed, and employment had expanded, especially among women and the elderly, leading to widespread reports of labor shortages. Judging by many indicators, the real economy seemed to be in danger of overheating. Yet, strangely, while the inflation rate edged up, it did not come close to 2%.

The low inflation rate was attributed to low inflation expectations and weak wage growth. Wages were not growing because actual inflation was still low, and actual inflation was still low because the public had adapted to the long era of low to zero inflation.

This situation was not necessarily bad from the viewpoint of fulfilling the BOJ’s implicit dual mandate. But then came the COVID-19 recession in 2020 and the first half of 2021, which was bad for both economic activity and the inflation rate. Even when the recovery arrived in the second half of 2021, it was slow. Japan still has not returned to its preCOVID GDP peak.

Things Get Complicated

In the second half of 2022, external factors, such as skyrocketing energy and food prices, finally pushed the inflation rate above 2% in Japan. Headline inflation rose above 2% in April 2022 and climbed to a 41-year high of 4.3% in January 2023; meanwhile, core inflation (excluding fresh food and energy prices) rose above 3% in October 2022 and hit 4.2% in January 2023.

Still, the Japanese inflation rate remained much lower than those of the United States (8%) or the United Kingdom (10%). In those economies and the eurozone, policy rates have been hiked sharply as central banks have responded to the charge that they fell behind the curve in 2021.

By contrast, the BOJ maintained QQE and YCC throughout 2022, reflecting Kuroda’s aim of achieving ontarget inflation “stably.”

As late as January 2023, the BOJ’s projection of the 2023 year-end inflation rate was still below 2%.

But inflation above 2% would not be maintained “stably.” As the interest-rate spread between the US and Japan widened, the yen started to depreciate against the dollar, falling from JPY 115 in January 2022 to JPY 150 in October 2022. The exchange rate’s slide ended only when the Ministry of Finance conducted large-scale interventions to sell dollars and buy yen.

As the yen depreciated and import prices rose in the second half of 2022, criticism of Kuroda’s “patience” intensified. The inflation rate of frequently purchased items like food, fuel, and electricity increased much more than the headline or core rates, making consumers unhappier than those standard indicators implied.

The YCC ceiling also faced growing opposition in the second half of 2022, when the BOJ was forced to open an unlimited purchase order for bonds at the ceiling rate (0.25% at the time). With mounting pressure on the BOJ to buy up bonds, the share of outstanding government bonds held on its balance sheet rose above 50%. More importantly, the yield curve started to dip (a sign of distortion) at the ten-year rate, indicating that the ten-year bond market was losing its price-discovery function.

In an effort to ease market pressure, the BOJ announced in December that it was widening the YCC band to 50 basis points. Kuroda hastened to explain that the goal was to maintain market functioning, not to signal an exit from the policy or a pivot toward monetary-policy tightening.

The chorus of criticism has since grown. Some commentators believe the BOJ has distorted the bond market so much that an eventual exit from YCC will be much more difficult. Others decry the BOJ’s inaction in the face of yen depreciation at a time when other central banks were rapidly abandoning their own negative interest rates and QE. Kuroda countered by arguing that the benefits of YCC outweigh its “side effects.”

Kuroda’s Legacy

The truth of that claim doubtless depends in part on one’s perspective (or portfolio). But Kuroda can claim three major achievements in his decade-long tenure. For starters, he demonstrated creativity in responding to changing market conditions, ultimately revealing both the depth and the width of the unconventional monetary-policy toolbox.

And when he doubled down on flexible inflation targeting, he did a good job of explaining the importance of such a framework to markets and the public. That was crucial to beating deflation, even if the work of achieving 2% “stably” is not yet done. Lastly, his policies contributed substantially to the remarkably strong recovery in economic activity before the COVID crisis.

Though achieving 2% inflation stably remains uncertain, there are promising signs for the near term. The wage-price stasis is now broken, thanks to supply-side developments and external factors – especially high energy and food prices. This year’s “spring offensive” (pay-raise season) should more than compensate for the recent inflation, establishing a new equilibrium of 2% inflation and 3% wage increases. In fact, many companies are granting wage increases above 3%.

That means there is light at the end of the QQE and YCC tunnel. The task of achieving 2% inflation targeting is now in the hands of a new team comprising Governor Kazuo Ueda and his deputy governors, Ryozo Himino and Shinichi Uchida.

Ueda, a former professor of economics at the University of Tokyo, was a member of the BOJ’s Monetary Policy Board from 1998 to 2005. Under the guidance of Professor Stanley Fischer, he earned a PhD from MIT and is a well-trained macro-financial economist. This is the first time an academic has been chosen as governor of the BOJ. His knowledge of data analysis should help guide the Bank toward its goal of achieving 2% inflation.