Essay analysis of the bank of japan's interest rate hike

Objectives: To examine the factors behind Bank of Japan’s decision to increase interest rates andassess the merits and demerits of the decision based on Japan’s economic context.Therefo

FOREIGN TRADE UNIVERSITY DEPARTMENT: FINANCE AND BANKING

-*** -ESSAY Advanced program in Finance and Banking

BANK OF JAPAN’S INTEREST RATE HIKE IN 2023

Class: KTE203E(2425-1) GD1+2.7

Teacher: Associate Professor Doctor Hoang Xuan Binh

K63

Hanoi, December 16th 2024

I Japan’s Economic Context: 5

II Why Bank of Japan decided to raised interest rates: 7III Economic impact of the rate hike: 13

IV Its global rippling effects: 16

V Future implications from the rate hike: 18

C REFERENCES 20

TABLE OF FIGURES

Figure 1: Japan’s benchmark interest rates from 1990 to 2024 6 Figure 2: Japan’s benchmark interest rates from 2014 to 2024 6 Figure 3: Annual percentage change in average monthly wages in Japan from 2014 to 2023 9 Figure 4: Low wage growth and subdued inflation from 2014 to 2023 9 Figure 5: Japan’s Rengo data on wage hikes from 1990 to 2024 with prediction to 202610 Figure 6: Japan’s headline, goods and services CPI from 1994 to 2024 10 Figure 7 : Yen’s exchange rate against the U.S dollar from 2020 to 2024 with a

prediction to 2025 11 Figure 8 Smaller Asian Equity Markets are outperforming this month Aug 2024 18

A OVERVIEW

I Objectives:

To examine the factors behind Bank of Japan’s decision to increase interest rates andassess the merits and demerits of the decision based on Japan’s economic context.Therefore, explore how such a simple monetary policy affects domestic and internationalmarkets

II Missions:

We want to understand thoroughly what had led to the Bank of Japan’s decision, theimpact of the interest rate hike, thus identify key lessons that can be derived from theBank of Japan's actions

III Why did we choose this topic:

This topic unveils multiple dimensions of macroeconomics, including inflation,

currency value, and monetary policy Japan’s situation is a unique case study for

understanding global economic interactions and the long-term effects of prolonged lowinterest rates Exploring this topic reveals how countries balance local economicconditions with the impacts on global financial stability, particularly for economiesdealing with deflation and high public debt

IV Structure:

To provide the context necessary, we first start with the introduction to Japan’seconomic context with its history with low or negative interest rates and background ondeflation, stagnant growth, a high debt-to-GDP ratio which creates a unique economicenvironment

Then, we provide the reasons why the Bank of Japan raised interest rates, which is aresult of the economic history of Japan and its current economic growth Only then, wediscuss the domestic implications of the rate hike on consumer spending, business

borrowing, and economic growth and its potential consequences for debt-ladencorporations and government debt sustainability.

Because Japan is a G7 nation, its action could cause a global ripple effect, especiallyfrom the carry trade impact: With increased rates, investors might avoid yen-basedborrowing, affecting international stock and bond markets The Yen is one of the mosttraded currencies in the world, which caused currency implications, such as yenappreciation, and its effects on Japan’s export competitiveness The rate hike also hasbroader impacts on global economic stability and capital flows between nations In theend, we would see what are the future implications of Bank of Japan’s action

V Methodology and Approach

Our research approach consists of analyzing macroeconomic data from official BoJstatements, and academic papers on Japan’s monetary policy We are also reviewedhistorical trends and comparing Japan’s approach with other central banks to understandtheir policy effectiveness We choose our information from reliable sources like financialdatabases, such as Bloomberg, for currency and interest rate data, the IMF and WorldBank report on Japan’s economic indicators and academic articles detailing Japan’s low-interest-rate policy and its effects on the domestic and global economy

B. CONTENT

I Japan’s Economic Context:

Japan is the only Asian country in the G7, but it has been slowly losing its position asone of the world’s leading economies since the mid-1990s After World War 2, despitebeing on the defeated side and suffering a huge loss in the aftermath of the war, Japanunderwent a rapid growth phase, which is often called the Japanese economic miracle,from 1955 to the first half of the 1970s (eds Patrick & Rosovsky, 1976) This growth wasfacilitated due to America’s support, as America provided Japan with loans from theWorld Bank and helped Japan minimize their military spending due to their militaryalliance The golden opportunity for Japan only came through the Korean War (John P.Bowen, 1984), when North and South Korea fought for the right of the peninsula As theUnited State is one of South Korea’s allies, demands for weapons to support the wargrew, and Japan was capable of filling those needs, thus was the final push that Japanneeded to grow itself economically

By the late 1980s, the Japanese economy experienced an asset price bubble caused byloan growth quotas dictated upon the banks by Japan's central bank, the Bank of Japan,through a policy mechanism known as the "window guidance”, and as the bubble burst, sodoes Japan’s economy, which is historically known as the lost decade (Werner, Richard,2005), which is still affecting Japan’s economy to this day From 2011 to 2019, Japan'sGDP grew an average of just under 1.0% per year (World Bank, 2021), and 2020 markedthe onset of a new global recession as governments locked down economic activity inreaction to the Covid - 19 pandemic

Japan's economic history and monetary policy reflect a unique response to persistenteconomic challenges Central banks, including the Bank of Japan (BOJ), have utilizednegative interest rates to stimulate economic growth and combat deflation This policyimposes costs on commercial banks and financial institutions holding large reserves,encouraging lending and economic activity The BOJ adopted this strategy to counter

negative shocks from China's economic slowdown and reinforce quantitative and

qualitative easing measures For decades, the BOJ maintained ultra-low interest rates,

including a negative interest rate of -0.1% since 2016 These policies were designed toencourage borrowing and spending, fostering economic growth in a stagnating economy(Japan Institute for Labour Policy and Training, 2024) However, despite these measures,inflation remained below the BOJ’s target of 2%, and consumer behavior did not alignwith theoretical expectations The era of quantitative easing (QE) and low borrowingcosts became a cornerstone of Japan’s monetary strategy but ultimately failed to fullyovercome deflationary pressures

Figure 1: Japan’s benchmark interest rates from 1990 to 2024

Figure 2: Japan’s benchmark interest rates from 2014 to 2024

Above are two historical line graphs of Japan’s benchmark interest rates from 1990

to 2024 that provide context for this prolonged period of ultra-low rates The chartsdemonstrate how these policies were part of a sustained effort to stimulate economicgrowth and combat deflation

Japan's reliance on low interest rates dates back to 1999 when the BOJ introduced azero-interest-rate policy (Feingold and World Economic Forum, 2024) Since then, short-term policy rates have been maintained at zero, near-zero, or slightly negative levels,except for a brief period between 2006 and 2008 when rates ranged from 0.25% to 0.5%.The Global Financial Crisis (2007–2008) marked a return to near-zero interest rates, atrend that persists today

Several factors contribute to Japan's prolonged low interest rates:

Economic Stagnation

The burst of Japan's asset price bubble in the early 1990s led to a prolongedeconomic stagnation characterized by slow growth and low productivity This crisis,accompanied by significant corporate debt and a banking sector collapse, created acautious lending environment (Werner, Richard, 2005) Additionally, the phenomenon of

"zombie firms," which survive only due to borrowing at minimal costs, highlightsstructural challenges in restructuring the economy (Denny, 2002)

Deflationary Pressures

Deflation exacerbates economic stagnation as consumers delay spending inanticipation of further price drops To counteract this, the BOJ aims to achieve a 2%inflation target through policies such as negative interest rates and quantitative easing.These measures are designed to increase consumer and business confidence in risingprices

Global and Financial Factors

Global economic trends, including interest rate synchronization and inflationpressures, influence Japan's policies Low rates help weaken the Yen, boosting exports bymaking Japanese goods cheaper abroad Financial stability considerations, such asavoiding defaults and supporting real estate markets, also justify maintaining low rates.

Public Debt and Fiscal Policy

Japan's public debt exceeds 250% of GDP, one of the highest globally Lowinterest rates enable the government to manage this debt sustainably withoutoverwhelming fiscal burdens However, deflation complicates debt management byincreasing its real value, creating additional challenges for policymakers

Japan's unique economic circumstances stem from its post-war history, marked byrapid growth from 1955 to the early 1970s due to American economic support and theKorean War's economic stimulus Today, Japan's high debt-to-GDP ratio, deflationaryenvironment, and stagnant growth underscore the limitations of monetary policy inaddressing structural economic issues Despite innovative policies such as quantitativeeasing and negative interest rates, Japan faces ongoing challenges in achieving sustainedeconomic recovery

II Why Bank of Japan decided to raised interest rates:

Rising Wages and Inflationary Pressures

In 2023, Japan experienced significant economic shifts, with average monthlywages rising by 4% and inflation reaching 2% (Trading Economics, 2024) This marks adeparture from Japan’s historical struggle with deflation and low growth, issues that havepersisted since the 1990s Higher wages directly contribute to greater disposable income,stimulating consumer spending and, consequently, driving up prices This wage-driveninflationary pressure has forced the Bank of Japan (BOJ) to reconsider its accommodativemonetary stance to prevent inflation from spiralling out of control

Figure 3: Annual percentage change in average monthly wages in Japan from 2014 to

2023

Figure 4: Low wage growth and subdued inflation from 2014 to 2023

The Two Triggers: Strong Wage Negotiations and Service Inflation

One of the key triggers for the BOJ’s decision was the robust outcomes of the 2023spring wage negotiations, which resulted in a 4% increase in wages (Japan ResearchInstitute, 2024) Initial Shunto results are expected in mid-March, and an estimatedaverage of major think tank views show a wage increase approaching 4% – even stronger

than 2022 as shown in Figure 5 Executives predict even bigger wage gains Nikkei’s

Shunto expectations survey of 100 CEOs, published on December 27 2023 indicated that35% of corporate bosses expected wage growth of 5 to 6 percent, while 19% expected 4

to 5 percent Several major companies have already announced intentions to hike by 7%

Figure 5: Japan’s Rengo data on wage hikes from 1990 to 2024 with prediction to 2026

Meanwhile, service inflation has passed the benchmark of 2 percent, probably

helped by a labor shortage in accommodations, retail and healthcare, as Figure 6 shows.

Figure 6: Japan’s headline, goods and services CPI from 1994 to 2024

Balancing Inflation and Growth

Japan’s inflation rate surpassed the BOJ’s 2% target in 2023, reaching 3%, creating

a complex policy dilemma (Trading Economics, 2024) While raising interest rates is aneffective tool to combat inflation, it also carries the risk of stalling economic growth.Japan’s history of deflation and economic stagnation underscores the fragility of itseconomic recovery, making any abrupt policy changes potentially destabilizing

Risks of Abrupt Action

Abruptly announcing an interest rate hike could exacerbate inflationary pressures,particularly in sectors experiencing rapid price increases Prolonged accommodativepolicies risk undermining the BOJ’s credibility and reducing its ability to manageinflation effectively in the future Furthermore, Japan’s low interest rates have fueledcarry trades, where investors borrow in yen to invest in higher-yield currencies Anyabrupt policy shifts could disrupt global financial markets, adding further complexity tothe BOJ’s decision-making process (Reuters, 2024)

Figure 7 : Yen’s exchange rate against the U.S dollar from 2020 to 2024 with a

prediction to 2025

Figure 7 shows fluctuations and volatility linked to monetary policy decisionswhich highlights the risks associated with suddenly raising interest rate in an increasinglyinterconnected global economy.

Conclusion: A Strategic Shift in Monetary Policy

The Bank of Japan’s decision to raise interest rates represents a pivotal moment in itsmonetary policy strategy Rising wages, inflationary pressures, and changing economicdynamics have created a new landscape that demands careful management While Japan’stransition from deflation to inflationary pressures signals progress, the BOJ facessignificant challenges in maintaining economic growth while addressing the risks ofrising prices

This strategic shift underscores the BOJ’s commitment to adapting to evolvingmacroeconomic conditions and balancing the competing priorities of price stability andeconomic expansion The decision highlights the complexity of monetary policy in arapidly changing global economy, with implications that extend beyond Japan’s borders

III Economic impact of the rate hike:

Such a decision comes with considerable trade-offs, as it introduces new challengesfor consumers, businesses, and the government while carrying significant globalimplications

By increasing interest rates, the BOJ has effectively This is intended to sloweconomic overheating and keep inflation in check, but it has ripple effects that coulddampen growth in other areas of the economy When interest rates rise, borrowingbecomes more expensive for consumers Families are less likely to take out loans for bigpurchases like homes, cars, or even appliances Instead, they tend to cut back ondiscretionary spending to manage higher loan repayments This dynamic is evident inJapan’s economic data, which shows that household spending fell by 1.3% in October

2024 compared to the same period in the previous year (Reuters, 2024) This decline in