Japan’s first step to new normal is the easiest

One and done?. Now for hard part. Bank of Japan on Tuesday scrapped negative interest rates, marking end of more than two deces of extraordinary efforts to prevent $4.2 trillion economy from stagnating. But nine-member board led by Governor Kazuo Ueda looks divided and sounds tentative about reaching its 2% inflation target and sparking a “virtuous cycle” of growth. That makes BOJ’s next steps perilous.

After months of speculation, BOJ voted 7-to-2 to set short-term borrowing costs at around 0.0% to 0.1%. For first time in 17 years, Japan will no longer have negative interest rates. Banks will now earn 0.1% interest on reserves parked with BOJ, making it easier for m to top up ir capital, inste of being charged for keeping some of ir balances at central bank. Ueda and his colleagues also ditched 1% upper-bound yield target for 10-year government bonds – anor unconventional policy that kept long-term rates low – but will continue buying sovereign debt and could ramp that up if re is a spike in long-term yields.

And BOJ will stop purchases of exchange-tred funds, real estate investment trusts and corporate debt, easily most controversial part of its policy. Markets responded calmly but oddly, with Japanese bond yields and yen falling rar than rising in response to higher rates.

Ueda is taking a leap of faith. economy just narrowly avoided recession and consumer expectations for price rises remain tepid. Indeed, workers were surprised last week that companies h agreed to wage increases far ahe of unions’ demands. BOJ is still not confident it will sustainably hit its 2% target nor that wages at small companies will rise. Yet foreign investors and some economists worry rate-setters could soon have to fight an inflationary spiral, partly because of labour shortages in ageing population.

And n re is legacy of its unconventional policies. BOJ needs a plan to shrink a balance sheet stuffed with about $4 trillion of government bonds and government securities. Its ETF portfolio alone might be worth 7% of $6.4 trillion market capitalisation of Tokyo Stock Exchange Prime market.

Japan doesn’t have a rule on how to deal with losses BOJ will incur whenever it starts selling its bonds. That could become a problem if concerns about BOJ profitability d to households’ anxiety about Japan’s future, say BofA analysts. y note that BOJ’s total assets are equivalent to 130% of nominal GDP, above U.S. Federal Reserve’s 32% and European Central Bank’s 53%. This makes Japan’s path towards higher rates uniquely fraught, and social risk is exacerbated by government debt at 252% of GDP, nearly twice ratio in United States.

Japan has taken a step towards monetary policy normality, but journey ahe is daunting.