BOJ's New Real Interest Rate Calculation Method…Higher Risk of Yen Carry Trade Liquidation? [Han Sang-chun's Reading of the International Economy]

Formalized at the meeting on the 18th

If the new calculation method is applied

Real interest rate around -2.5%

"The policy rate needs to be raised further"

Supports Ueda's claim

Recent sharp rise in Japanese government bond yields

US heads toward financial easing

Yen carry trade in turmoil

As the final month of the year arrives, major central banks are holding consecutive meetings to decide next year's monetary policy direction. The US Federal Open Market Committee (FOMC) meets for two days starting the 9th this week, and the Bank of Japan (BOJ) will hold its two-day meeting starting the 18th next week.

Ahead of the BOJ meeting, Japanese government bond yields have been rising sharply. The 10-year yield surged to the 1.95% range, the highest in 18 years since July 2007, and many expect it will soon exceed 2%. There is also growing international market interest in whether the longest-dated 30-year yield will surpass 4%.

A key reason for the rapid rise in Japanese yields is the change in the real interest rate calculation method to be formalized at this meeting. Until now, real rates were calculated as 'policy rate - consumer price inflation', but under the new method the policy rate is replaced by the uncollateralized overnight call rate (in the US, the federal funds rate), and consumer price inflation is replaced by core consumer price inflation excluding seasonally volatile fresh food and energy.

The uncollateralized overnight call rate is currently about 0.5%, and core consumer price inflation is around 3%. Calculated under the new method, the real interest rate is around -2.5%. Prime Minister Sanae Takaichi requested a rate freeze to maintain a weak yen policy, but Governor Kazuo Ueda's indication of the need for additional rate hikes is also behind this.

By contrast, at the FOMC a policy rate cut is being treated as a fait accompli. The probability of a rate cut, which was in the low-30% range a month ago amid peak AI bubble talk, has recently surged to around 90%. Since the 1980s, when the market's probability of a rate cut exceeded 90%, the US central bank (the Fed) has often acquiesced.

With expectations that the Fed will be filled with 'pro-Trump' figures including next year's chair, interest is growing in the direction of monetary policy. US President Donald Trump has consistently argued that the policy rate should be lowered to 1%. Achieving this would require adjusting the Fed's policy objectives. Since its founding in 1913, the Fed has prioritized price stability, but in 2012 an employment goal was added, establishing a dual mandate. Since then the Fed has tended to place relatively more weight on job creation. It is natural for President Trump, a businessman, to put more emphasis on job creation than on price stability.

There is also a high likelihood that the inflation target will be raised. After the dual mandate, monetary policy was operated with an inflation target of 2% and an unemployment target of 3.5%. In the process after COVID-19 of tolerating the unemployment rate up to the upper bound of the full employment range (3.5–4.2%), views emerged that the 2% inflation target should be raised to the 4% range. The 4% argument advocated by Paul Krugman of the City University of New York is a representative example.

If the Fed prioritizes job creation and raises the inflation target, the US stock market is likely to continue its upward trend. Global investment banks such as JPMorgan and Deutsche Bank project that the S&P 500 will exceed 8,000 by the end of next year, more than 12% higher than current levels.

Of course, there are variables. If the BOJ raises rates while the Fed pursues financial easing, the risk of yen carry trade capital being liquidated increases. Generally, yen carry trade liquidations burden global equities. However, even if the Trump administration shifts exchange rate policy from a weak dollar to a strong dollar while US Treasury yields remain absolutely higher than Japan's, the US stock market's upward trend is unlikely to be derailed. The Korean stock market is also expected to follow the same path as the US market.