BOJ signals December rate hike, but path beyond 1.5% remains uncertain

ETMarkets.com

A December rate hike appears increasingly likely, but the BOJ faces uncertainty over how far it can raise borrowing costs.

According to a Reuters report, the BOJ's immediate challenge will be to contain mounting inflationary pressures without undermining an economic recovery in a country where households and businesses have become accustomed to decades of ultra-low borrowing costs.

The central bank last week signalled a shift in its policy priorities after declaring progress in its 14-year battle to achieve its inflation target. Policymakers are now increasingly focused on preventing inflation from overshooting the 2% target, reinforcing expectations of further monetary tightening.

Ueda indicated that the BOJ had decided to hold off on an immediate rate increase to assess economic and price developments more closely. However, his comments that policymakers would discuss monetary policy with particular attention to upside inflation risks at the next meeting strengthened expectations of a December hike.

Japan's policy rate currently stands at 1.25%. A December increase would take it to 1.5%, potentially marking another significant step in the country's departure from its prolonged era of ultra-loose monetary policy.

Economic data have also strengthened the case for further tightening. Japan's economy expanded at an annualised rate of 1.4% in the second quarter, supported by continued corporate spending despite geopolitical and economic headwinds. Meanwhile, core inflation reached 2.1% in September, remaining above the BOJ's 2% target as rising price pressures offset the impact of fuel subsidies.

Former BOJ official Nobuyasu Atago, now chief economist at Rakuten Securities Economic Research Institute, indicated that a December rate increase was highly likely. However, he said the bigger question was whether the central bank would continue tightening next year, when another increase could take the policy rate to 1.75%, potentially close to levels considered neutral for the economy.

BOJ faces uncertainty over neutral interest rate

According to Reuters, the central bank's cautious approach reflects uncertainty over Japan's neutral interest rate, the level at which borrowing costs neither stimulate nor restrict economic activity.

BOJ staff estimates put Japan's nominal neutral interest rate in a broad range of 1.1% to 2.5%. However, the central bank has avoided identifying a precise level, given that neutral rates cannot be directly observed and estimates vary depending on the economic models used.

This uncertainty has complicated the BOJ's policy outlook. While inflationary pressures are strengthening the case for higher rates, policymakers are also monitoring the impact of monetary tightening on household finances and corporate borrowing.

Ueda has acknowledged concerns that lending conditions are becoming tighter for smaller businesses, although he has maintained that overall financial conditions remain accommodative.

The challenge is particularly significant for Japan, where decades of deflation and near-zero interest rates have left households and businesses with limited experience of sustained monetary tightening.

Unlike other major central banks, the BOJ has spent most of its existence since gaining independence in 1998 combating disinflation and deflation. It now faces the difficult task of raising rates without disrupting an economy still adjusting to a higher-inflation environment.

BOJ policymakers divided over pace of rate increases

The BOJ's policy board also has limited consensus on how far interest rates should rise.

Hawkish policymaker Naoki Tamura has argued that Japan's neutral interest rate is likely close to 2% and advocated steady increases in borrowing costs. Another hawkish member, Hajime Takata, has supported faster tightening and unsuccessfully proposed raising the policy rate to 1.5% at the BOJ's latest meeting.

In contrast, former academic Junko Koeda has adopted a more cautious position, indicating that the neutral rate is likely significantly above 1% without specifying how far borrowing costs should rise.

Two policymakers appointed by Prime Minister Sanae Takaichi are also considered to favour a more cautious approach, having opposed the September rate increase.

Nomura Securities executive rates strategist Mari Iwashita said the BOJ likely still considers its policy rate some distance below neutral, strengthening the possibility of an increase to 1.75% by around March next year.

However, the central bank could pause after reaching that level as it assesses the impact of previous rate increases on economic activity, lending conditions and inflation.

For now, markets are increasingly focused on the likely December move, while the BOJ's longer-term policy trajectory remains uncertain as it navigates an unfamiliar monetary environment.