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On July 28th the Bank of Japan (boj) took markets by surprise. At the end of a two-day policy meeting Ueda Kazuo, the central bank’s governor, announced an unexpected change to its increasingly expensive policy of yield-curve control. The boj raised its cap on ten-year government-bond yields, which it defends with regular and sometimes vast purchases, from 0.5% to 1%. Ten-year yields climbed to around 0.57% after the announcement, the highest in nearly a decade.

Surging inflation over the past two years has led central banks around the world to raise interest rates forcefully. Japan’s central bank has been a stubborn outlier, keeping most of its monetary-stimulus measures—including negative interest rates and aggressive bond purchases—firmly in place. All told, the boj’s ultra-low interest-rate regime, introduced in an attempt to boost the country’s sluggish rate of economic growth and prevent outright deflation, has now been active for a quarter of a century. Tweaking yield-curve control is not quite an abandonment of the regime. It does, however, set the country on course for higher rates.

Under yield-curve control, the boj buys government bonds when yields approach the stated cap—pushing yields, which move inversely to bond prices, back down. The approach has been in place since 2016, when it was introduced as an alternative to huge asset purchases, which were distorting the bond market. In the past year the policy has come under pressure as inflation has soared worldwide.

In January the boj was forced to make enormous bond purchases—surpassing ¥13trn ($100bn) in one week—in order to defend the policy. Hedge funds have short-sold government bonds, expecting that the boj eventually will have to abandon the policy. Every extra boj bond purchase increases eventual losses on the central bank’s portfolio should yields eventually rise. And with the boj owning vast amounts of government bonds, there are few left for others to trade, leaving the market increasingly illiquid.

Most economists had therefore expected the boj to eventually junk or tweak the policy, though not until later in the year. The boj says that allowing a wider trading range will bring flexibility, allowing the bond market to function better, whichever way the economic winds blow. The central bank also said that it would be “nimbly conducting market operations” when the ten-year yield was between 0.5% and 1%. The central bank seems to be giving itself wriggle room to buy bonds, even if yields do not bump up against the new upper bound. In doing so, it risks causing confusion about its goals.

Despite the boj’s insistence that the change to yield-curve control is not an act of monetary tightening, any loosening of the band inevitably means higher market interest rates, since yields were already bumping up against the previous cap. Even if the boj does not want to fire the starting gun on a cycle of tighter policy, the move is “effectively akin to a rate hike”, as Naohiko Baba of Goldman Sachs, a bank, has written.

For now there are few advocates of more aggressive tightening at the boj. But rate rises no longer look as unlikely as they did. Based on the price of interest-rate swaps, investors expect short-term interest rates to rise from -0.1% now to zero in a year’s time. Data released on July 28th showed core inflation (excluding fresh food and fuel) in Tokyo rising by 4% year-on-year in July, twice the boj’s target. What happens in the labour market will be crucial. Signs of broader pressures on wages are still limited, but the shunto, springtime wage negotiations, saw promises of the largest wage rises in three decades.

Years of ultra-low interest rates have left Japan exposed to higher interest rates, whether market or official ones. The most obvious source of risk is the country’s government debt, which on a net basis ran to a staggering 161% of gdp last year, and which will become much more expensive to service. Despite low borrowing costs in recent years, the government already spends 7.4% of its annual budget on interest payments—more than it does on defence, education or public infrastructure. Higher interest rates for any sustained period would put huge pressure on Japan’s fiscal arithmetic.

Thus the BoJ faces a balancing act. Backing away from its yield-control policies without sending yields surging will require immaculate communication. If inflation fades as the boj hopes, officials may just pull it off. But if price pressures are more sticky and sustained, then painful monetary tightening will follow. ■

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