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The Bank of Japan (BoJ) has recently shifted its policy stance, marking a significant turning point in its decade-long easing cycle. Despite inflation running above target for several years, the BoJ had maintained a dovish tone due to concerns over disappointing domestic growth. However, the BoJ has now adopted a hawkish stance, even as it revises growth expectations lower. This shift is likely in response to political pressure stemming from weak foreign exchange rates and imported inflation.

In July, the BoJ implemented a small rate hike, raising short-term rates to 0.25%. Additionally, it announced a plan to halve Japanese Government Bond (JGB) purchases by the first quarter of 2026, although it will still be buying ¥3 trillion per month in 18 months’ time. BoJ Governor Kazuo Ueda emphasised that real rates remain very low and additional hikes may be necessary if reflation continues. The market reacted with concern, with both JGB yields and equities falling and foreign exchange markets starting to price in the unwinding of the yen carry-trade.

These concerns may be overblown given the BoJ's likely gradual approach and the resilience of the US economy. The BoJ's policy normalisation is driven by persistent inflation, which is threatening to re-accelerate due to a weak yen and tight domestic supply, particularly in the labour market. By raising rates gradually, the BoJ aims to control yen depreciation and imported inflation, allowing nominal wage growth to catch up with inflation and supporting domestic demand. If the BoJ raises rates twice a year, the short-term can reach 1.0% by mid-2026, with the 10-year JGB yield potentially even higher. That said, the BoJ is expected to remain active in the JGB market, continuing to buy bonds through early 2026 and beyond to dampen rate volatility and maintain debt sustainability.

Japanese yen rallied significantly following BoJ decisions

Data as at 30 September 2024. Source: Bloomberg

Real rates may also rise if inflation decelerates. Nevertheless, even with slightly higher rates, the environment would remain accommodative for borrowers, given the net positive private sector balance sheets. However, parts of the market that have benefited from years of cheap Japanese funding may start to underperform as the yen carry-trade unwinds. Strained household consumption is also a risk, with real growth averaging -1.4% annually over the last three quarters. If real wage growth does not turn positive in the next 3-6 months, Japanese households may retrench further, leading to a decline in spending and halting reflation.

Wage growth in Japan remains low

As at July 2024. Source: OECD