Japan’s Departure from Ultra-Easy Monetary Policy

As Japan inches towards an exit from its ultra-easy monetary policy, a significant regime change looms for its banking system, triggering potentially massive shifts in fund flows, according to insights from a former banking regulator.

With inflation surpassing its 2% target for an extended period, the Bank of Japan (BOJ) has signalled intentions to end its negative interest rate policy and phase out other components of its extensive stimulus package in the coming months. Tokio Morita, former vice minister for international affairs at the Financial Services Agency (FSA), anticipates a smooth transition from negative rates by the BOJ, emphasising the importance of avoiding abrupt policy tightening that could destabilise Japan’s banking sector.

However, Morita warns against underestimating the repercussions of Japan’s departure from decades of ultra-low interest rates. He foresees significant changes in the behaviour of financial institutions, depositors, and borrowers, particularly as domestic lending becomes more profitable. Morita highlights the potential for increased competition among financial institutions for deposits, possibly leading to higher interest rates, even from institutions with questionable financial stability. Such a scenario, he cautions, could foster excessive risk-taking in the banking sector.

Morita underscores the BOJ’s prolonged suppression of both short-term and long-term interest rates, emphasising that easing this grip would mark a fundamental regime change for Japan’s banking industry. He stresses the importance for financial authorities to ensure a smooth policy transition without causing major shocks to financial markets and the broader financial system.

The global implications of Japan’s policy shift are also significant, Morita notes. The debate surrounding how this transition could impact fund flows worldwide holds considerable importance, reflecting the interconnectedness of global financial markets.

Drawing on his experience in global financial regulation, including involvement in managing the fallout from the Lehman Brothers collapse in 2008, Morita provides valuable insights into the challenges and considerations surrounding Japan’s monetary policy shift.

In its efforts to reflate growth and achieve its 2% inflation target, the BOJ has maintained short-term interest rates at -0.1% and the 10-year bond yield around 0% since 2016. Last year, the BOJ began relaxing its tight control on 10-year bond yields, indicating a willingness to allow long-term rates to move more freely as it prepares to lift short-term rates out of negative territory.