OECD Urges Japan’s Central Bank to Gradually Raise Interest Rates

TOKYO (Reuters) — The Bank of Japan should gradually raise short-term interest rates and make its bond yield control policy more flexible, if inflation stays around its 2% target and is accompanied by sustained wage growth, the OECD said on Thursday.

While the BOJ made tweaks to yield curve control (YCC) last year to loosen its tight grip on long-term interest rates, markets could challenge the policy again if inflation remains above its 2% target and global yields go up, it said.

The central bank should thus continue efforts to make YCC more flexible, such as by raising the 10-year bond yield target or moving to a short-term yield target, the Organisation for Economic Cooperation and Development (OECD) said.

The BOJ should also gradually raise short-term rates from early 2024 if inflation stays around its 2% target, wage growth accelerates and the output gap closes, the OECD said in its 2024 report on Japan.

“Japan is at a turning point, with inflation more likely to settle durably around the 2% inflation target than at any time since its inception,” the report said on the prospects for achieving the BOJ’s price target that was introduced in 2013.

“Greater flexibility in the conduct of yield curve control and a gradual modest increase in the short-term policy interest rate are warranted, based on projections of sustained inflation and wage dynamics,” it said.

With inflation having exceeded 2% for well over a year, many market players expect the BOJ to pull short-term interest rates out of negative territory this year in a historic shift away from its prolonged ultra-loose monetary policy.

Any such move would follow steps the BOJ took last year to phase out YCC, a policy that sets a 0% target for the 10-year government bond yield, such as by watering down a rigid 1% cap set for the yield to a loose reference.

BOJ Governor Kazuo Ueda has stressed the bank’s resolve to keep ultra-loose policy settings intact until sustained achievement of 2% inflation, accompanied by durable wage rises, comes into sight.

The OECD warned that uncertainty around Japan’s inflation outlook was “exceptionally large.” While a slowdown in the global economy could weigh on wages, a tighter labor market could lead to higher-than-projected wage growth, it said.

“In this context, the key challenge facing the BOJ is how to durably achieve its inflation target without significantly overshooting” its inflation target, while safeguarding financial stability, the report said.

In the event of a rate hike by the BOJ, policymakers must be vigilant to potential spillovers on domestic and global financial stability, the OECD said.

“Communicating the current and future monetary stance clearly and in a timely manner is also key,” it added.