TOKYO -- Japan's central bank is finding itself under increasing pressure to raise the target long-term interest rate, but doing so is going to be far from straightforward. Higher interest rates would send bond prices down, which in turn would harm bank finances as they hold large amounts of government bonds.
The market does not care about the risks, and the Bank of Japan is forced to contain the any signs for rising rates.
Masatsugu Asakawa, vice minister of finance for international affairs, arrived in Washington on Feb. 7 with a mission: Stop President Donald Trump from criticizing the BOJ's monetary easing and the weakness of the yen.
Asakawa met with a U.S. official at the West Wing just three days ahead of Japanese Prime Minister Shinzo Abe's meeting with Trump.
Tokyo chose for Asakawa to meet Kenneth Juster, who had been appointed senior staff at the U.S. National Security Council just five days earlier. As deputy assistant to the president for international economic affairs, the former undersecretary of commerce has the key job of coordinating international economic policy and integrating it with national security and foreign affairs. He will also serve as the president's representative and lead U.S. negotiator, the job known as the "Sherpa," for annual summits of advanced nations.
What had had Tokyo so worried was a comment from Trump in late January: "Every other country lives on devaluation. You look at what China's doing, you look at what Japan has done over the years. They play the money market, they play the devaluation market and we sit there like a bunch of dummies."
Rate hike speculation
If the BOJ continued to maintain the yield of benchmark 10-year Japanese government bonds at near-zero levels by flooding the financial system with huge amounts of cash even as the U.S. Federal Reserve weighs up a potential rate hike in March, it would drive the spread between the two countries' interest rates. That in turn would further weaken the yen.
This is just the scenario Japan wants to see, but Trump's comment threatened to throw a spanner in the works for Tokyo.
The market was quick to respond to the remarks, with long-term rates at one point rising to 0.15% on speculation that the BOJ would be pressured into raising the long-term rate target. In order to fight back, the central bank bought 723.9 billion yen ($6.37 billion) worth of bonds -- nearly twice the BOJ's average purchase amount -- on limit orders with target prices exceeding market levels.
During the meeting, Asakawa tried to convince his opposite number that the BOJ's monetary policy is not pursuing a weaker yen, and got the nod from Juster, according to officials.
In the end, when Abe visited Washington, Trump did not bring up monetary policy or the yen.
Jared Kushner, senior adviser to the president and his son-in-law, had called for an increased role for the NSC, which resulted in more power for Juster. Some believe this has helped tilt the administration toward prioritizing stronger ties with Japan, rather than worsening economic friction.
Trials in store
The market has since subsided, but the central bank now openly says it will raise the target once inflation of 2% is in sight.
Former BOJ policy board member Sayuri Shirai said she thinks a BOJ rate hike "will be very early" and she is not alone.
But Hideo Hayakawa, senior executive fellow of Fujitsu Research Institute and a former BOJ executive director, said the central bank will face "a real difficult aspect of long-term interest rate controls" from this point. He argued that if the BOJ hikes rates, bond prices would naturally go down. This in turn would seriously hit finances at Japanese banks, which hold huge amounts of Japanese government bonds.
"There could be a massacre," said Izuru Kato of Totan Research.
But the BOJ should have foreseen the difficulties associated with an exit policy, or the policy to normalize the unconventional monetary easing.
In 2010, the Fed considered introducing a long-term interest rate target. But if market participants' assumptions were that it was inevitable for interest rates to rise, the Fed would have been forced to keep buying bonds from the market. In the end, the risk prompted the Fed to give up the idea.
BOJ executive director Masayoshi Amamiya, who works out monetary policy, said there is a view among European and U.S. scholars that there is no need to normalize monetary policy despite the difficulties.
With just one year remaining of Gov. Haruhiko Kuroda's tenure, the BOJ has yet to come up with a viable exit strategy after having purchased 400 trillion yen's worth of bonds.