BoJ's Unorthodox Policies Come Back to Haunt Japan

The Bank of Japan's unorthodox policies have been criticized for their ineffectiveness in stimulating growth and their role in contributing to Japan's 'lost decades' of stagnation and deflation. The yen's current depreciation to 40-year lows against the US dollar is seen as an aftereffect of these policies, which began to reverse and normalize in 2024.

Japan's post-war growth was spectacular, bringing it from being a devastated nation to the world's second-largest economy by the 1980s. However, this hypergrowth ended with the bursting of its real estate and stock market bubble in 1990, which was partly caused by the Plaza Accord of 1985.

The BoJ responded to this downturn by pioneering unorthodox policies such as zero and negative interest rates, quantitative easing (QE), and yield curve control (YCC). These measures were intended to stimulate domestic consumption and overcome disinflation but have had mixed results. The BoJ's balance sheet has expanded significantly, with the central bank becoming Japan's largest bond and equity holder.

The policies have also created distortionary effects on the economy, including arbitrage opportunities such as the yen carry trade. This involves borrowing yen at low interest rates to invest in other countries' assets, effectively shorting the yen. The BoJ now faces a conundrum: raising interest rates could increase debt servicing costs and erode the value of its balance sheet, but not doing so may stoke further inflation and depreciation.

The situation poses risks to global financial markets, particularly if the yen carry trade reverses suddenly. This could impact US Treasuries, stocks in the US and other countries, and developing nations reliant on cheap yen-denominated loans.