Investors watch central banks and their policy decisions closely due to the impact those decisions can have on both the stock market and the economy as a whole. Any unexpected changes can send shockwaves through the local market. Changes in large economies can lead to sizable ripples across the globe.

That’s exactly what happened last week when the Bank of Japan announced that it would increase ten-year bond rates to as much as 0.5% from 0.25%.

Japan is currently the third-largest economy in the world and the second-largest economy in Asia, behind China. The yen is one of the most popularly traded and held currencies, with the IMF estimating that it is the third-most commonly held reserve currency in the world.

Much of that economic strength came as a result of post-World War II economic booms in the country. Japan recovered from the devastation of the war relatively quickly, making major investments in electric power, coal, steel and chemical industries. By the mid-1950s, about ten years after the war, Japanese economic output matched pre-war levels.

Between 1953 and 1965, Japan’s GDP increased by more than 9% per year. Many attribute the massive growth to the country’s robust education system, a crucial part of building a technologically advanced economy.

Growth continued at a strong pace through the 1970s and 1980s. In the early 1990s however, Japan entered its “Lost Decade.” Spurred by a stock and real estate bubble that peaked in 1989, the economy entered a deflationary period.

The Bank of Japan responded with massive stimulus, which failed to do much. Between 1991 and 2003, real GDP growth in Japan was only 1% annually, well below typical rates. At the same time, debt levels continued to rise.

Since then, Japan has been something of an outlier when it comes to economic policy and results among developed nations. It saw greater contractions in its economy during the 2008 recession and has continued with loose monetary policies for longer and to a greater extent than many other nations. For example, the Bank of Japan’s target short-term interest rate has been negative since 2016.

What happened?

On December 20th, the Bank of Japan announced changes to how it intends to control bond yields. Previously, the BoJ had a target of 0% for its ten-year bonds but allowed rates to move by as much as 0.25% from the target. Though the 0% target is remaining the same, the BoJ will now loosen that aforementioned limit, allowing rates to vary by as much as 0.5% from the target.

In effect, this allows the interest rate on these bonds to rise, a slight tightening of the money supply in the country.

At the same time, the BoJ announced that it would step up its bond purchases, a loosening of fiscal policy. Many believe that this combination of higher rates but more bond purchases indicates that the Bank of Japan is simply adjusting its monetary policy rather than strictly looking to tighten it.

In a news conference, the Governor of the Bank of Japan, Haruhiko Kuroda said, “This change will enhance the sustainability of our monetary policy framework. It's absolutely not a review that will lead to an abandonment of YCC (yield curve control) or an exit from easy policy.”

Explaining the reasoning behind the change, Kuroda continued, "Overseas market volatility has heightened from around spring ... While we have kept the 10-year bond yield from exceeding the 0.25% cap, this has caused some distortions in the shape of the yield curve. We, therefore, decided that now was the appropriate timing to correct such distortions and enhance market functions."

In response to the news, the yen spiked in value and Japanese stocks fell on investor fears that this is only the beginning of rate increases.

What it Means for Investors

One of the realities of today’s interlinked global economy is that policy changes on the other side of the globe can have large impacts back home.

Inflation in Japan remains above the 2% target set by the Bank of Japan, so many wonder if this is a prelude to further tightening to fight inflation. Shares in Japanese banks also rose by more than 5% on the announcement, indicating broad sentiment that the time of low-interest rates might be ending.