You are attested as an Institutional Investor, but this page is intended for a Borrower.
You are attested as a Financial Advisor / Intermediary, but this page is intended a Borrower.
You are attested as an Individual Investor, but this page is intended for a Borrower.
Earlier this year, we noted the upside risks to the Bank of Japan’s policy rates, highlighting that the growing mismatch between monetary and fiscal policy would likely warrant a benign realignment of the policy mix. Amongst a number of risks, we noted that an overheating U.S. economy and/or further pressures on the yen would likely require a more aggressive pace of policy rate hikes. Following hawkish statements from new Federal Reserve Chair Kevin Warsh and the recent coordinated yen intervention by U.S. and Japanese authorities, these risks appear to have crystalised. With pressure on the yen likely to persist, we examine how fast and how high the BOJ could take rates from here.
Key takeaways:
The macro outlook, financial stability risks, and other constraints have tempered the BOJ’s pursuit of policy normalisation.
However, there are signs that these hurdles are fading, clearing a path for the BOJ to raise rates more aggressively amid yen pressure and a resilient domestic economy.
An initial set of hikes — bringing the policy rate to the midpoint of the BOJ’s estimated neutral range — could be followed by a more rapid sequence if data remain resilient.
Thus far, the measured pace of monetary policy normalisation from the BOJ reflected four key constraints:
1. Macro fundamentals
Given the prolonged period of deflation in Japan, relatively limited evidence has emerged that underling inflationary pressure is surpassing the BOJ’s 2% inflation target. Moreover, a series of negative shocks (e.g. tariffs and energy) has threatened the outlook.
2. Monetary strategy
Due to the zero lower bound on interest rates, it is harder for central banks to reflate than get inflation under control. As a consequence, the risk of making a policy error is asymmetric when policy rates are near the zero lower bound. That is, it is better if policy is too late than too early (resulting in a return to deflation). In the past, the BOJ tried normalising policy rates too soon, only to have to bring them down again to zero.
3. Financial stability
After a prolonged period of near-zero rates, as in Japan, a sharp rise in yields risks sharply lower asset prices and a tightening squeeze on borrowers. Such a repricing could trigger a financial stability event that cascades through the real economy.
4. Political pressure
As we are seeing across a number of developed markets, Japan’s fiscally expansive administration appears keen to keep monetary conditions easy. This has been reinforced by growing pressure on the central bank and the appointment of sympathetic monetary policy committee members.
However, recent developments suggest that these constraints may be fading away. The following sections assess how each variable has changed:
1. Macro fundamentals: Solid
Macro fundamentals appear solid despite numerous challenges (e.g. tariffs and the Middle East energy crisis), giving more confidence in reaching the 2% inflation target.
The data flow suggest that the Japanese real economy remains healthy. Fears that the latest cost shock could squeeze households and firms have failed to materialise. Corporate margins have held up, and private investment and the Japanese consumer have remained healthy.
Moreover, policymakers were concerned that resurging energy costs could — perhaps counterintuitively — lead to lower domestically generated inflation by squeezing household spending on non-energy goods and services. The data thus far do not suggest this, and given the time lapse since the crisis began, it now seems less likely. Indeed, there is growing evidence that the structurally tight labour market is translating into nominal wage growth consistent with the 2% inflation target.
Finally, unabated fiscal pressures in the face of accelerating demographic trends and geopolitical shifts continue. More clarity is expected around the fiscal plans of the current government this autumn, maintaining pressure on long-term rates in the interim.
2. Monetary strategy: Headroom for cuts
The further away the policy rate is from zero, the more headroom there is for cuts.
In other words, the higher the policy rate goes, the more balanced it becomes, meaning the risks of an asymmetric policy declines. With the policy rate now at 1% for the first time in three decades, the BOJ has more space to cut rates if needed.
3. Financial stability: Two sides of risk
Being behind the curve can create financial stability risks as well.
Policy rates that are too low can incentivise excessive borrowing, leading to overinflated asset prices. The BOJ noted in its latest Summary of Opinions that the risk of keeping rates too low could mean having to hike aggressively and causing a “double shock.”
Moreover, a slower pace of quantitative tightening (QT) can help contain any potential financial stability risks stemming from a more decisive path of policy rate normalisation by stabilising demand at the long end of the curve.
4. Political pressure: Easing
There may be more political policy space for higher policy rates, considering indications from the Fed that tighter U.S. policy may be needed (Exhibit 1) and the slower pace of the BOJ balance sheet runoff.
Political pressure not to tighten policy may be declining, given recent pressure from U.S. policymakers to raise rates. In addition, recent appointees by the Takaichi administration seem more receptive to the need to hike (though it is still early days).
Exhibit 1:
BOJ’s policy rate remains low relative to major peers
How fast and how high for the BOJ?
The BOJ assesses the range of the nominal neutral interest rate for the Japanese economy to be between 1.0-2.5%. Therefore, we see the next three hikes as relatively easy, as this would bring the policy rate only to the midpoint of neutral. However, this could happen against a backdrop of higher Fed interest rates, suggesting that the latest yen intervention is likely to offer only limited relief
Exhibit 2:
Yen intervention may deliver only limited relief (JPY per USD)
Once the policy rate is around 1.75%, we could see the four constraints fall further away if data indicate that financial stability risks are balanced, the 2% inflation target has been sustainable achieved, and macro fundamentals remain resilient.
At that stage, we could possibly see a more rapid pace of rate hikes towards the top end of neutral beginning in 2027, lifting the policy rate even further from its three-decade high.
The Bank of Japan will hold a two-day policy meeting ending Sept. 18. Subscribe to the Long Story Short blog for more updates.
5884306_PGIM
