Central Bank Policy
TheBoJ’sLeapofFaithontheRoadtoNormalisation
5 mins
In one fell swoop, a hawkish Bank of Japan lifted its policy rate above zero and announced quantitative tightening (QT) at its July meeting.1 Policymakers additionally signalled that if the expected outlook materialised, then the Bank would “continue to raise the policy interest rate.” We see growing signs of an inflation reset underpinning the latest decision, with the dramatic weakening of the yen adding further upward pressure. That said, weak consumption puts a question mark over whether such fast-paced normalisation of policy is entirely warranted by the domestic situation.
Wednesday’s historic moment in monetary policy surfaced amidst growing confidence amongst Japanese policymakers that the BoJ’s 2% inflation target could be achieved in a sustainable manner (Fig. 1). Recent data indicate a broadening of wage growth, and households’ inflation expectations have continued to drift up. Corporate price setting expectations have increased, and there are growing concerns about the domestic spillovers of a weak yen vis a vis the USD.
Figure 1
Confidence in sustainable, 2% inflation underpinned the BoJ’s rate hike (%, 3-mo. MA)
Macrobond
That said, the Bank of Japan is taking somewhat of a leap of faith that higher rates are warranted domestically. As we have seen in other developed economies outside of the U.S., consumption remains weak (Fig. 2). Japanese households have been hit by a sharp rise in the cost of living due to the double-whammy of rising energy and import prices. Having been stuck in a too-low inflation equilibrium for so long, there is a risk that rapid normalisation snuffs out a pick-up in self-sustaining domestic demand.
Figure 2
The hike risks extinguishing a self-sustained improvement in Japan’s domestic demand (index, 2019 Q4=100)
Macrobond
On QT, the BOJ followed the playbook of other central banks by announcing a gradual, predetermined path to shrink the size of its balance sheet relatively early in the hiking cycle. Until fairly recently, such a move had been almost unthinkable. That said, the gradual run-off pace of ¥400 billion per quarter suggests a cautious approach to avoid triggering market disorder.
Our view is that rates will now be on pause for the remainder of this year. A subsequent review of QT in June 2025 could see the run-off accelerate to ¥1 trillion per quarter, assuming the impact on financial conditions is judged to be marginal.
Market Reaction
The market did not fully factor in a rate hike for Wednesday's meeting, and although long-term interest rates rose on the initial reports of a policy rate hike, the market quickly reversed course. Indeed, some investors may have positioned for the risk of a more aggressive reduction in JGB purchases and consequently covered those trades when the QT announcement arrived as expected. After the short covering faded, interest rates rose again.
This increase emerged as some investors may be factoring in a more aggressive rate-hiking trajectory by the BoJ based on the adjustments to its Outlook for Economic Activity and Prices report. Hawkish comments, such as the Bank will “continue to raise the policy interest rate,” were added, while dovish language, such as “domestic and international economic and financial uncertainties remain high” and “the Bank expects the accommodative financial environment to continue for the time being,” were deleted.
In terms of the Japanese Yen (JPY), the currency continued its strengthening that started after the benign U.S. CPI report on July 11th and the subsequent, marginal decline in U.S. Treasury yields.
Since the Federal Reserve embarked on a rate hiking cycle in March 2022—thus widening the real rate differential between the U.S. and Japanese markets—the JPY has remained under pressure. This prompted investors to use the yen as the funding currency in long carry positions in higher-yielding currencies, such as the Mexican Peso (MXN), Brazilian Real and, more recently, the Turkish Lira. This funding strategy has performed well over the past two years, leading to a significant build up in positioning.
However, as those trades unwind, some high-beta currency pairs—the MXN/JPY cross is down 11% from July’s peak—are seeing sizable reversals (Fig. 3).
Figure 3
Carry trades unwind on yen stabilization (CFTC CME net non-commercial futures positions; JPY 10-year z-scores)
J.P. Morgan, CFTC, Bloomberg
In general, we see the unwinding of these carry trades as logical given the prospects that Japanese and U.S. policy rates continue to converge. Furthermore, as the momentum that took USD/JPY to the highs of 161.95 in early July has waned, it is closer to a fair-value level as indicated by short-term interest rates.
In the event the BoJ pursues a moderate and shallow hiking cycle, many global currencies, including the U.S. dollar, may maintain a significant interest-rate advantage. It is likely, in our view, that we are now entering a new, more stable trading range for the currency, and the heavy lifting of any further move in USD/JPY will likely be driven by the scale of the Federal Reserve’s cutting cycle.
Outlook
While pressure on the yen can exert implied pressure on the BoJ, we believe that the BoJ can take a relatively patient approach to future rate hikes. Indeed, the BoJ indicated it will modify policy to “neutral” if its price stability target is achieved between the second half of FY2025 and FY2026. Yet, BoJ Governor Ueda indicated that the pace of policy correction would be gradual considering that the neutral policy rate remains uncertain.
Although we remain uncomfortable with the BoJ’s assessment that consumer spending is “firming up despite the effects of rising prices and other factors,” the BoJ appears confident of a recovery in consumer spending, and the judgment may be based on a risk-balancing approach.
As far as quantitative tightening, the impact of the reduction in JGB purchases may be small. The BoJ holds more than 50% of JGBs issued, which we believe—as a stock effect of its holdings—pushes the 10-year JGB yield down by about 100 bps. A reduction of 7-8% in JGB holdings over about two years would probably have an impact of only about 10 bps, depending on the term structure of the reduction.
Going forward, we maintain a mildly bearish view on JGB yields. While the JGB curve stands out as one of the steepest in the developed world, the low level of nominal yields should keep pressure on the BoJ, and we see scope for yields in the belly of the curve to move higher as a result.
In sum, the BoJ's policy reaction function has become easier to understand following the change in the monetary policy framework in March, and the next interest rate hike is likely to be within the six months that the market had previously assumed. For the time being, attention will focus on the extent to which the existing rise in import prices and current wage increases will be passed on to retail prices. Beyond that, if the 2025 Spring wage negotiation delivers a wage increase close to this year's level, a rate hike to “neutral” will likely be within sight.
1 The prior policy rate was set at a range of 0-0.10%.
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