The Bank of Japan completed another step on its normalisation path by raising its policy rate by 25 bps to 0.5%, marking its highest nominal level in 17 years. Following the BoJ’s relatively abrupt hike and the consequent market volatility last July, officials faced key challenges in navigating the latest decision. The Bank sought to strike a balance between not sounding too dovish, thus risk further yen weakening, whilst equally not sounding too hawkish and potentially triggering another sharp market repricing.
Although the BoJ is keeping its options open with regards to the pace and endpoint for this cycle, we expect an additional rate hike later this year. A steady, gradual approach to policy normalisation would allow the BoJ to finally move away from extraordinary policies and their costly side effects, whilst simultaneously avoiding a return to deflationary territory.
The unexpected reset offered by the pandemic shock looks to have finally jolted Japan out of its multi-decade experience of uncomfortably low inflation. The macro data flow in Japan remains encouraging: activity data still appears acceptable and—crucially—underlying, domestically-generated inflation drivers are gathering pace. For example, the latest indicators from Japanese businesses suggest that the coming spring wage negotiations will be at levels that would underpin a sustainable return to the 2% inflation target. Indeed, the BoJ’s inflation outlook was revised higher in its concurrently published Outlook Report, which added that “upward pressure on wages and prices is likely to be stronger than suggested by the output gap, given that firms in many industries have started to face labor supply constraints."1
In terms of global factors, Japanese policymakers acknowledged the uncertainty from the Trump administration in the context of a healthy U.S. economy. The relative market stability in the post-inauguration days left little reason for the BoJ to delay its decision.
With the BoJ’s latest step behind it, the critical question becomes where policy may go from here. The Bank’s normalisation path is clearly supported by the macro data, the currency impact from a strong U.S. dollar as well as the BoJ’s latest thinking on the country’s experience of low inflation and prior policy experiences. The takeaway from the Bank’s broad review is that extraordinary polices worked, but were not particularly effective and came with a high cost.
Our interpretation of the review is that policymakers are committed to the normalisation path, but only gradually. At 0.5%, rates are now at a psychologically important level: the Bank has been unable to keep rates above that level since the mid-1990s (it was last at 0.50% in 2008), and they are hoping that this time will be different. Reflecting this cautious approach, our view is that rates will rise by a further 25 bps this year, but potentially not until the Autumn. However, if the underlying inflation rate in Japan accelerates beyond 2%, the BoJ would likely accelerate the pace of rate hikes.
Longer term, the BoJ also stated that it would remain on the current trajectory if the current “very low real interest rate” is taken into account and the economic and price outlooks are realized.” The reference to a “very low real interest rate” suggests that the BoJ envisages an appropriate policy rate of at least 1%.
Market Implications
Given the foreshadowing of the BoJ’s latest hike, the decision was almost fully priced in, resulting in minimal market disruption. However, intermediate JGB rates rose slightly amidst perception of the BoJ’s strong stance on inflation.
Meanwhile, the yen has not been able to appreciate in any sustainable manner, even with nominal rates at multi-year highs. This is likely due to the fact that real rates in Japan remain quite negative, in sharp contrast to its own history as well as relative to other major economies where real rates sit at multi-decade highs (Figure 1).
Figure 1
The real policy rate in Japan remains remarkably low from a global perspective (nominal policy rate – CPI inflation; %)
Source: Macrobond
Continuation of the BoJ’s cautious hiking approach in the face of elevated inflation, as well as its increased inflation forecast, points to a steady weakening bias for JPY in a world where real rates otherwise remain elevated.
1 “Outlook for Economic Activity and Prices (January 2025),” Bank of Japan, January 24, 2005.
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