Normalization of Interest Rates

Ichiro Suzuki

Japan’s long-term interest rates are inching up almost daily. Benchmark 10-year government yield has rose to 2.33% on January 20. This level of long-term rates was last seen near the end of the 20th century when Japan was at a relatively early stage of persisting deflation caused by a banking crisis. Several years later, bank balance sheets were finally cleaned up with massive injection of tax payers money for recapitalization. When the Japanese banking sector was reconstructed at last, that of the rest of the world got caught in the worst crisis in seventy years with collapse of the housing market in the U.S. and Europe sinking into a deepening hole of exotic securities that were created by subprime mortgage loans. 

Japan was engulfed in the deepest global recession since the 1930s. Even worse, the market drove the Japanese yen to unprecedented levels. The surge was engineered not by the strength of the economy that Japan didn’t have but because of limited room on interest rate reductions. While the central banks around the world were slashing rates fiercely, rates in Japan were already close to zero with little further space to go lower. That made real interest rates in Japan rise as the economy sank into deflation again. Higher real interest rates made the yen look attractive to foreign investors looking for trading opportunities. The Fed’s Ben Bernanke launched aggressive quantitative easing to prevent the U.S. economy from falling into a depression. The move pushed hot money’s flow into Japan as the BOJ’s Governor Shirakawa was slow to act. Return of deflation drove long-term government bond yield closer to zero. 

Shinzo Abe returned to power near the end of 2012, determined to fight the persisting mild deflation. ‘Abenomics’ called for three arrows that consisted of large scale fiscal stimulation, aggressive monetary easing and deregulation. Of the three, the first two arrows were shot with a fierce passion while deregulation was carried out much less passionately. Abenomics proved to be successful, lifting risk asset prices that have been mired in doldrums for years. Real estate and stock markets soared. Behind relative success of the policy, every effort was made to contain long-term interest rates in order to keep expansionary monetary policy intact. 

Then, just about the time when it looked the Japanese economy was returning to a reasonable shape and looked ready to embrace higher interest rates, the coronavirus shock hit the global economy. Along with all other central banks, the BOJ flooded the market with liquidity for fear of the virus driving the world into another depression. Small and medium business owners borrowed relentlessly. Many had to do so simply to survive the heightened uncertainty, and some did so for the luxury of an access to near free money. As it turned out, the economy got through the depressed period much faster than it was feared. As the economy began to move toward normalcy, those low cost loans had to be repaid but some business owners found it unable to do so. In 2022, macro economic environments turned decisively negative for over-leveraged SMEs, with structural shifts in the global economy, dramatic weakening of the yen, and acute labor shortages that all contributed to higher inflation. BOJ Governor Kazuo Ueda declared to unwind the long-lasting ultra accommodative monetary policy. In 2025, however, the BOJ hiked policy rates only twice. With the second hike in December, the policy rates at 0.75% are the highest since 1995. 

The market doesn’t care about the BOJ’s political considerations. It’s none of the business of the market if higher policy rates drive SMEs to the brink of bankruptcy. They want proper interest rates that suit the current macroeconomic conditions. Long-term interest rates, therefore, are rising relentlessly. At over 2.3%, however, the ten-year government bond yield is still below the CPI. Money is still too cheap, making perfect sense for those who can borrow and invest in risk assets. Houses and condos have gone out of reach for the majority of households. In the foreign exchange market, the yen has been under pressure due to low real interest rates, in the polar opposite condition that bought the yen for high real interest rates in the years that followed the global financial crisis. Then, a weak yen further fuels consumer prices. These are small prices to pay for being overly kind to fragile SMEs. Right? These companies are one of the major reasons behind the Japanese economy’s low productivity, which has been lagging behind the rest of the developed world for years. While few have been too willing to impose structural changes on this weak link of the economy, the market is beginning to force changes whether politicians like it or not. 

Higher interest rates create greater interest payment burden, of course. In 2026, government bond-related expenses, mostly interest payments, are going to account for a third of the proposed budget. On the other hand, however, there is a brighter side to it. Rising interest rates are the results of the economy that is in reasonably good shape. The government is raking in greater amount of tax revenue generated by brisk economic activities, through higher prices and trading volume in the real estate and stock markets, greater corporate profits and higher consumption tax revenue that reflects inflation. In the years of mild deflation, the Ministry of Finance was persistently troubled from revenue shortfalls due to weak economy. Amid rising interest rates, the ratio of the government debt to GDP has been stable or has even declined a little though it still stands at whopping 240% approximately. It remains to be seen how the dynamics between revenue and interest expense plays out. As long as the latter really doesn’t go out of hand, the recent development in the bond market can be considered as a part of a normalization process. Nonetheless, this will be walking on thin ice, with not much margin of error. 

About the author: Mr. Suzuki is a retired banker based in Tokyo, Japan.