Bank of Japan made a landmark rate pivot. Here’s what happens next

Japan’s central bank on Tuesday finally ended its experiment with negative rates and unconventional easing tools which were aimed at reflating the world’s fourth-largest economy.

The Bank of Japan’s decision came just days after Rengo, Japan’s largest federation of trade unions, said ongoing “shunto” wage negotiations between Japan Inc and unionized employees have so far yielded a provisional weighted average 3.7% spike in base pay. This was even more robust than last year’s gains, which were the steepest in three decades.

BOJ Governor Kazuo Ueda had repeatedly said these talks would be key to sustainable price increases that would inform any decision to hike rates for the first time in 17 years. BOJ policymakers expect higher salaries to lead to a virtuous spiral with domestic demand fueling inflation.

Prior to Tuesday, the BOJ had barely budged from its ultra-loose monetary policy posture despite “core-core inflation” — which excludes food and energy prices — exceeding its 2% target for more than a year, as policymakers viewed that price increases were largely imported from overseas.

“The BOJ has taken a bit of a punt today on the expectation that the very substantial wage increases in a great number of firms is actually going to deliver household spending growth,” Rob Carnell, head of Asia Pacific research at ING, told CNBC Tuesday after the BOJ released its decision after its March policy meeting.

“At the moment, they don’t know that,” he cautioned.

The BOJ will now look to utilize its short-term interest rate as its primary policy tool. It will employ an interest rate of 0.1% to current account balances held by financial institutions at the central bank from March 21, while encouraging the uncollateralized overnight call rate (another interest rate used as a policy lever by the bank) to remain at around 0 to 0.1% — effectively raising interest rates from -0.1% previously.

Shortly after the BOJ announcement, Japan’s largest banks, including Mitsubishi UFJ Financial Group, Sumitomo Mitsui Financial Group and Mizuho Financial Group, announced they would raise interest rates on ordinary yen deposits. 

There are some other highlights of its policy decision:

• It said it’d abolish its yield curve control, which it used to cap longer-term interest rates at around zero; and stop its purchases of exchange-traded funds and Japan real estate investment trusts.
• The BOJ also pledged to gradually slow its purchases of commercial paper and corporate bonds, with the aim of stopping this practice in about a year.
• It would resort to “nimble responses” in the form of increased Japan government bond purchases and fixed-rate purchases of JGBs, among other things, if there is a rapid rise in long-term interest rates.

CNBC takes a look at what could next happen:

The decision Tuesday sparked a sharp selloff in the Japanese yen, sinking to more than 150 yen to the dollar — a level that’s previously prompted intervention from Japanese authorities.

Barclays economists said that a decrease in the upper bound of offer sizes for JGBs suggested that the BOJ is looking to gradually reduce its purchases.

One of the biggest fears is the extent of any repatriation to Japan.

Decades of accommodative monetary policy in Japan — even as other global central banks tightened policy in the last 12 months — have also concentrated carry trades in the Japanese yen, given the vast interest rate difference between Japan and the U.S. and other parts of the world, keeping the Japanese yen weak. Carry trades involve borrowing in a low-yielding currency to fund investments in higher-yielding assets elsewhere.

An unwind of the traditional yen carry trade along with a return of Japanese capital to its domestic bond market could trigger wider volatility. Japanese investors have looked elsewhere for better returns given years of artificially depressed interest rates in their home market.