By Katharine Neiss (main picture), deputy head of global economics and chief European economist, PGIM, and Seiji Maruyama, head of Japan fixed income, chief investment officer, PGIM.

Earlier this year, we noted the upside risks to the Bank of Japan’s (BOJ) 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 US 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.

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 US 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 US 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).