Japan reaction: Hawkish tone, but weak economic backdrop will keep a lid on hikes this year

As expected, the Bank of Japan (BoJ) unanimously voted to reduce their purchases of government bonds at July’s meeting by 400bn yen per quarter, reducing the overall pace from around 5.7trn yen currently, to 4.9trn by end-2024 and around 2.9trn yen by end-25. Less anticipated, however, was the move to increase the target for the uncollateralized overnight call rate – the Bank’s key policy rate – from 0.1% to 0.25% at its July meeting, with a vote split of 7:2. The Board highlighted the fact that economic activity and prices were “developing generally in line with the Bank’s outlook” and that wage increases appeared broad based. In addition, import prices are again rising on a year-on-year basis, an upside risk the statement noted required attention. Then Bank, however, did reaffirm that real interest rates are expected to remain significantly negative and that “accommodative financial conditions will continue to firmly support economic activity.”

Regarding the outlook, the BoJ struck a more hawkish tone than in recent statements, noting that the policy interest rate will continue to increase, and the degree of monetary accommodation adjusted if the outlook presented in the July Outlook report is realised. Note that Bank of Japan revised down its forecast for GDP growth in FY24 by 0.2 percentage points to 0.6% but left its FY25 forecast unchanged at 1%. And on the price front, the BoJ revised down its forecast for CPI ex. fresh food inflation by 0.3ppt to 2.5% in FY24 and revised up its forecast for FY25 by 0.2ppt to 2.1% but left its forecasts for CPI ex. fresh food and energy unchanged at 1.9% in FY24 and FY25.

Are further hikes on the horizon then? We think the answer is a cautious yes. While the outlook for CPI inflation is broadly in line with our forecasts – with higher wage costs and import prices applying upward pressure to underlying inflation over the coming quarters – we think there are downside risks to the growth outlook. Indeed, we see a risk that the recovery in private consumption is sluggish, even once real incomes start to rise again in the second half of the year, as ongoing caution in the face of higher prices means households save at least some of the additional cash. As a result, we think the BoJ will struggle to increase the policy rate by 25bp this year, instead waiting until Q1 2025, leaving the uncollateralized overnight call rate at 0.25% end-24 and 0.5% end-25. Of course, if the economic data come in stronger than we anticipate, further hikes in 2025 are on the cards.