The Bank of Japan (BOJ) faces a critical decision: when and by how much to raise interest rates. While markets anticipate a hold on rate hikes this week, Governor Kazuo Ueda is expected to provide insights into the BOJ’s future monetary policy trajectory. A key debate within the central bank revolves around Japan’s neutral interest rate, the level at which monetary policy neither stimulates nor restricts economic activity. This level will significantly influence the pace and extent of future rate hikes.
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BOJ’s Balancing Act: Inflation Target vs. Economic Growth
BOJ staff estimates suggest short-term rates could rise to at least 1% without hindering economic growth. This assessment considers Japan’s inflation-adjusted real neutral interest rate, estimated to be between -1% and +0.5%. With inflation reaching 2%, a 1% rate hike theoretically wouldn’t stifle growth. However, recent weak consumption data raises concerns that this neutral rate might be lower. The BOJ aims to push its policy rate towards neutral by early 2027. Most analysts predict an initial rate hike from the current 0.25% by March, a first step in this multi-year process.
Former BOJ board member Takahide Kiuchi anticipates a slower pace of rate increases once rates reach 0.5%, as this level approaches the estimated neutral rate. He projects a 0.5% rate by January and 0.75% around September next year, believing the BOJ perceives Japan’s neutral rate as slightly below 1%. Once the 0.5% threshold is crossed, a more data-driven approach, carefully evaluating the economic consequences of each hike, is expected.
Navigating Uncertainty: Defining Japan’s Neutral Rate
The BOJ ended a decade of radical stimulus in March and raised short-term rates to 0.25% in July, based on the assessment that Japan was nearing its 2% inflation target sustainably. Governor Ueda has indicated that rates will approach Japan’s neutral level if the economic recovery continues. However, pinpointing the precise neutral rate remains challenging due to a lack of reliable estimates after two decades of near-zero interest rates.
While hawkish board member Naoki Tamura advocates for raising rates to at least 1% by late next year, other members have been less explicit about their views on the neutral rate. Internal discussions reveal concerns that Japan’s neutral rate might be lower than 1%, citing sluggish growth and inflation despite historically low borrowing costs.
Japan’s annualized economic growth slowed to 1.2% in the third quarter of 2023, down from 2.2% in the previous quarter. Consumption growth was a mere 0.7%. Core inflation, after reaching a peak of 4.2% in January, has steadily declined to 2.3% in October, with limited signs of wage-driven inflation. This trend, combined with easing import cost pressures, reinforces the view within the BOJ that aggressive rate hikes are unnecessary.
Cautious Approach Favored Amid Economic Uncertainty
A lower neutral rate estimate reduces the pressure on the BOJ for frequent rate increases. Even a 0.5% rate would represent a level not seen since 2007-2008, and public reaction to consistent rate hikes remains uncertain. Some BOJ officials emphasize the need for a cautious approach, warning that exceeding the neutral rate could prematurely cool the economy. The delicate balance between achieving the inflation target and maintaining economic stability necessitates a measured response as the BOJ navigates this complex economic landscape. The upcoming policy meeting will offer valuable insights into the central bank’s strategy for managing this challenge.
