What’s the Next Step for the Bank of Japan?

In March, the Bank of Japan (BOJ) abolished its eight-year-old negative interest-rate policy, hiking rates for the first time in 17 years by raising its benchmark rate to 0%–0.1%. Though this move was long awaited, it’s only one step on the path of normalization.

We think the BOJ should take their time progressing along that path. In our view, slow normalization of policy is best; the resulting low volatility, higher yields and steeper yield curve describe a friendly environment for bond investors. But what specifically is the ideal next step on the normalization path for the BOJ?

Interest Payments May Constrain Further Rate Hikes

One possible next step for the BOJ would be to hike rates again. But that could result in a prohibitive increase in interest payments.

We can determine how much of an increase is too much by calculating the breakeven rate for cash flow—that is, the highest interest rate at which the interest income from the BOJ’s excess reserves remains sufficient to cover the interest expenses on its liabilities.

Given excess reserve deposits of ¥548 trillion, an interest rate of 10 basis points (bps)—the higher end of the latest rate hike range—generates an interest payment of ¥548 billion. Two possible break-even rates are 60 bp, based on fiscal year 2022 ordinary profits, and 80 bp, based on fiscal year 2023 ordinary profits. Interest payments at these levels would run ¥3.3 trillion to ¥4.4 trillion, respectively. Beyond this point, further rate hikes could be possible if the BOJ were to tap the reserve’s unrealized bond trading losses.

But there’s another—and we think better—option for the next step toward normal.