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The Bank of Japan’s Seductive Widow-Maker Trade

After having maintained near-zero interest rates for decades, the Japanese central bank may be forced to hike rates if inflation remains persistently high. But Japan’s enormous government debt and vulnerable banking sector mean that doing so could trigger a systemic financial crisis.

CAMBRIDGE – Could Japan become the world’s next great growth story? Billionaire and legendary investor Warren Buffett seems to think so. And the International Monetary Fund expects the Japanese economy to grow by 1.4% in 2023 – an impressive figure for a country whose population has steadily declined for the past 14 years.

But the Japanese economy could also be a ticking time bomb. Its labor market is tight, inflation remains stubbornly high despite the introduction of gasoline subsidies, and the yen’s real exchange rate has reached a three-decade low. After decades of maintaining near-zero interest rates, it is unclear whether the Bank of Japan can raise them without sparking a systemic financial crisis.

While the BOJ’s new governor, Kazuo Ueda, has said that the Bank will maintain its ultra-loose monetary policy, he also acknowledged the global economy’s “very high uncertainty.” Given the forces driving up inflation and interest rates worldwide, it is increasingly clear that Japanese monetary policy can no longer be conducted in isolation.