Japan is taking another step away from making easy money

The people who operate the levers of Japan’s economy are in a bind: The country’s low interest rates, long used to boost growth, are now far out of step with other major economies. Bridging that gap is difficult.

The yen is at near-record lows against the U.S. dollar, threatening to impose long-term inflation on Japan, which for years has struggled with the opposite problem: deflation. But if policymakers in Tokyo loosen their grip too much and interest rates rise too high, they could impose higher borrowing costs on Japanese companies and consumers and wreak havoc on financial markets.

On Tuesday, the central bank, the Bank of Japan, tried to tip the scales by announcing a policy aimed at pushing up bond yields. The bank said it would use 1 percent as a baseline for 10-year Treasury yields, rather than a ceiling, and said it expected inflation to be higher than previously thought. In July it had announced that it would raise interest rates above 0.5 percent, which had been the bank’s ceiling.

Yields on 10-year Japanese government bonds responded accordingly on Tuesday, rising to around 0.9 percent.

Decisions by the Bank of Japan are reverberating around the world, especially in US markets. Interest rates in the United States are well above those of Japan; yields on 10-year U.S. Treasury bonds recently rose above 5 percent, a level not seen since 2007.

Interest rates in the United States have been rising since the Federal Reserve, the U.S. central bank, began a sustained effort to curb inflation, fueled by an economic rebound from the coronavirus pandemic. The Fed is expected to stand firm on Wednesday with interest rates already at a 22-year high.

With interest rates so high elsewhere, Japanese investors – and many others – have shifted their money into government bonds to take advantage. Japan is the largest foreign holder of U.S. government debt, according to the report official federal data.

By buying into US government bonds, Japanese investors have increased demand for dollars and contributed to the yen’s decline. As a result, the Bank of Japan was forced to support the yen this year while still trying to keep interest rates low.

Interest rates on government bonds are used as a benchmark for many other types of debt, including mortgages, credit cards and business loans. The cost of borrowing affects the growth of an economy.

Central banks act as gatekeepers. They set the short-term interest rate which then influences the long-term market interest rate. The Bank of Japan has also been buying up its own debt in an attempt to increase its value, or price, and decrease its yield, or payout.

“Uncertainty surrounding the Japanese economy and prices is extremely high,” Kazuo Ueda, the bank’s governor, said at a news conference on Tuesday. “And it is necessary to pay close attention to developments in the financial and currency markets and their impact on the Japanese economy and prices.”

The central bank’s move can be seen as “a pre-emptive measure aimed at limiting the risk of rising foreign interest rates,” Tomohiro Ota and Yuriko Tanaka, analysts at Goldman Sachs, wrote in a research note.

By allowing government bond yields to rise, the Bank of Japan is giving back some of the appeal of its domestic debt, hoping this will strengthen the yen at the expense of the dollar. The United States is the world’s largest economy, and Japan the third, and its currencies are among the most heavily traded.

Stefan Angrick, a senior economist at Moody’s Analytics in Tokyo, said the Bank of Japan had moved “in the direction” of raising rates over the past year. “The bank is clearly uncomfortable with the weak yen,” he added.

Last week, the yen fell to its weakest level against the dollar since October 2022, then recovered on Monday as rumors emerged of a possible change in Bank of Japan policy. However, the yen initially weakened after Tuesday’s announcement, closing in on the October 2022 low.

The bank is in a “difficult situation,” Mr. Angrick said in a note. “Mini steps toward tightening are at least partly intended to prevent the yen exchange rate from falling further. But excessive tightening risks further weakening the economy.”

The central bank’s move comes at a crucial time in global markets. Geopolitical instability – wars in Europe and the Middle East and protectionist trade policies of the world’s leading economies – have increased nervousness about the sudden rise in US Treasury yields, which is undermining borrowing costs for consumers and businesses around the world. could threaten the resilience of the economy.

The Bank of Japan’s decision could reinforce some of these fears in the United States, especially if it leads to a noticeable shift in demand for government bonds among Japanese investors, which could push U.S. yields even higher.

Hisako Ueno And Ben Dooley reporting contributed.