By Leika Kihara
TOKYO, Nov 2 (Reuters) – Bank of Japan Governor Kazuo Ueda has all but locked in a December rate hike, but left investors guessing how much further it could go once rates approach neutral territory, a largely unfamiliar setting after decades of ultra-loose policy.
Beneath the BOJ’s hawkish message lies the challenge ahead. As inflationary pressures become more entrenched, policymakers must judge how quickly households and businesses, long conditioned to near-zero borrowing costs, can absorb higher rates without derailing a fragile economic recovery.
The BOJ last week declared victory in its 14-year battle to hit its price target and stressed its policy has entered a new phase focused on avoiding an inflation overshoot, reinforcing its hawkish bias.
Ueda said the BOJ decided to forgo a rate hike to scrutinise economic and price developments “a bit more” – language that echoed remarks made in July before the bank raised rates in September.
He also said the board will debate policy focusing on upside price risks, including at the next meeting, signalling a high probability of a hike in its policy rate to 1.5% in December.
Japan’s economy expanded an annualised 1.4% in the second quarter, as firms continued to boost spending despite headwinds from the Middle East conflict. Annual core inflation hit 2.1% in September, exceeding the BOJ’s 2% target as mounting price pressures outweighed the dampening effect of fuel subsidies.
“Judging from the latest BOJ communication, a rate hike in December is pretty much a done deal,” said former BOJ official Nobuyasu Atago, who is currently chief economist at Rakuten Securities Economic Research Institute.
“What’s less clear is what happens next year because a subsequent hike would bring the BOJ’s policy rate to 1.75%, which could be around levels deemed neutral to the economy.”
CASE FOR AMBIGUITY
The source of the BOJ’s ambiguity is its limited confidence over where Japan’s neutral rate actually lies.
BOJ staff calculations place Japan’s nominal neutral rate, which neither heats up nor slows the economy, at between 1.1% and 2.5%, offering a rough guide to how far policymakers could lift borrowing costs.
But like many central banks, the BOJ has been deliberately vague about where that rate sits in practice as it cannot be observed and estimates can vary depending on models used.
That uncertainty explains why the BOJ is warning about inflation risks without committing to a steady march higher in rates. While warning of price pressures, Ueda has also stressed the need to watch how higher borrowing costs affect corporate and household lending.
“We’re hearing that smaller firms’ lending conditions are tightening, so we’ll keep a close watch on whether such calls will spread,” Ueda said, while maintaining that overall financial conditions remain accommodative.
The challenge posed by uncertainty over neutral rates is more pressing for the BOJ than for its overseas counterparts.
With its policy rate still at just 1.25%, officials face pressure to push borrowing costs toward neutral relatively quickly to avoid fuelling excess inflation.
Yet Japan’s three-decade-long experience with deflation may also have left households and businesses unusually sensitive to higher rates, a risk the BOJ says warrants caution.
Compounding the challenge, the BOJ is navigating unfamiliar terrain. Since gaining independence in 1998, it has spent most of its existence battling disinflation and deflation, leaving it with limited experience of how an economy accustomed to ultra-low rates responds to sustained monetary tightening.
There is no consensus within the board on how far the BOJ should push up rates. Hawks like Naoki Tamura argue the neutral rate is likely near 2% and have called for steady rate increases. Another hawk, Hajime Takata, also favours faster hikes and proposed unsuccessfully on Friday a hike to 1.5%.
Former academic Junko Koeda appeared more cautious, saying only the neutral rate was “likely significantly above 1%.”
The two doves appointed by Prime Minister Sanae Takaichi likely are in the cautious camp, having dissented against the September rate hike.
“All in all, the BOJ probably still thinks its policy rate is some distance away from neutral. That would cement the case for hiking rates up to 1.75% by around March next year,” said Mari Iwashita, executive rates strategist at Nomura Securities.
“After that, the BOJ could pause. It probably hasn’t made up its mind yet.”
(Reporting by Leika KiharaEditing by Shri Navaratnam)
