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Investors are increasing their bets that the Bank of Japan will need to keep raising borrowing costs as a weaker yen fuels inflation and puts pressure on the central bank to tighten its policy to prop up the currency.
The BoJ’s calculus has been complicated by the shifting tone in the US, where Federal Reserve chair Jay Powell has signalled that interest rates may need to stay high to tame inflation. Traders have built up bets that the Fed could even tighten policy again.
That has pushed the yen to 34-year lows against the dollar, sparking an unusually blunt warning from BoJ governor Kazuo Ueda that the central bank could act if the weaker yen impact became “too big to ignore”. The yen slid 0.28 per cent on Thursday to ¥155.62 a dollar.
It comes only a month after Ueda started to unwind years of unorthodox BoJ policy with an exit from negative interest rates. Further increases in borrowing costs would be gradual to avoid sending shockwaves to global markets, Ueda indicated at the time.
But the yen’s depreciation is stoking inflation by pushing up prices of imported goods. Core inflation, which excludes volatile food prices, rose 2.6 per cent from a year earlier in March.
If inflation continues to stay above the BoJ’s 2 per cent target, Ueda may need to keep raising rates at a faster pace than he would want, analysts said, a scenario Japanese officials want to avoid since it could trigger a spike in government bond yields and abrupt shifts in investment flows.
Two-year forwards on the overnight index swap rate — a benchmark of monetary policy expectations — show that investors now anticipate the BoJ’s policy rate to rise above 0.6 per cent from near zero following the shift in Fed expectations.
Many Japanese investors expected the BoJ’s policy rate would not rise above 0.5 per cent despite an end to negative rates. The rate has not been past that level since Japan’s 1998 financial crisis, according to Naka Matsuzawa, Japan macro strategist at Nomura.
Initially following the March meeting, investors had forecast the BoJ’s next rate rise would be in September, but markets now expect the change in July, implying that the BoJ could raise borrowing costs twice more this year.
“If markets start pricing in two rate hikes a year, that’s already a relatively fast pace and if expectations go over that, that means [inflation] is getting out of BoJ’s control,” Matsuzawa, said, adding that two rate rises would be akin to four by the Fed given Japan’s low underlying real interest rate.
Kazuo Momma, executive economist at Mizuho Research Institute and a former head of monetary policy at the BoJ, said Ueda could end up in the same situation as Powell in 2020, when the Fed was forced into a rapid cycle of rate increases to tame inflation.
“That’s the biggest risk the BoJ faces at the moment,” Momma said at a panel during an annual meeting of the International Swaps and Derivatives Association in Tokyo. “Interest rates are now at zero, but inflation at 2 per cent could become certain and concerns about an upside risk may arise.”
The BoJ’s two-day policy meeting began on Thursday, and it is not expected to make a further increase in interest rates immediately.
But analysts expect the BoJ to raise its core inflation outlook for fiscal 2025, and the focus will be on whether Ueda will strike a hawkish tone regarding future rate increases.
Momma said the BoJ would also want to start to cut purchases of Japanese government bonds to normalise market activity, which could precede a rate increase.
The weaker yen is a mixed blessing for Japan’s economy. It has boosted inbound tourism and fuelled a surge in corporate profits earned overseas. But a softer currency has raised living costs, hurt consumption and made it harder for smaller businesses to raise wages.
For decades, the biggest challenge for the BoJ had been to achieve a mild increase in prices to ensure the economy did not sink back into deflation. But it wants price rises to be sustainable, driven by rising domestic wages and consumption, rather than the result of external pressures.
“I think markets are underestimating the potential for the BoJ to do more. There’s compelling evidence that we have big structural change under way, particularly in the labour market,” said Derek Halpenny, head of research for global markets at Mitsubishi UFJ Financial Group.
Guiding currency levels is not part of the BoJ’s mandate, so central bankers historically have been reluctant to address weakness in the yen.
But the currency decline has been mainly driven by the gap in interest rates between Japan and the US, and analysts said Ueda was more willing to co-ordinate closely with the government to address the issue.
On Tuesday, finance minister Shunichi Suzuki issued his strongest verbal warning that “the groundwork has been laid” for Tokyo to take “appropriate action” in the currency market, pointing to a rare joint statement by the US, Japan and South Korea expressing “serious concerns” about the decline in the yen and won.
“The BoJ will not raise interest rates just because of the weaker yen, but it could bring forward the timing of its rate hike,” said Takahide Kiuchi, executive economist at Nomura Research Institute and a former BoJ board member.
“After the BoJ ended negative interest rates last month, it gained a new weapon to influence the currency markets through verbal intervention as well as an actual rate hike.”
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