BOJ Considers Rate Hike and Bond Purchase Reduction

The Bank of Japan (BOJ) is set to evaluate the possibility of raising interest rates during its upcoming meeting and is expected to reveal plans to substantially cut its bond purchases in the years ahead. This move indicates a deliberate effort to gradually roll back its extensive monetary stimulus measures. The decision to increase rates will depend on the BOJ's assessment of whether consumer spending will rebound and if inflation remains consistently around its 2% target.

The BOJ's approach to monetary policy began with a significant shift in April 2013 when it established a 2% inflation target to combat long-standing deflation and promote sustainable economic growth. However, due to falling international oil prices, the BOJ struggled to achieve this target, prompting further interventions. In February 2016, the central bank adopted a negative interest rate policy and significantly expanded the money supply by purchasing long-term Japanese government bonds (JGBs). Prior to this, the BOJ had focused on short-term bonds, leading to a flattened yield curve for JGBs. The shift resulted in negative yields even on long-term bonds up to 15 years. Banks reduced their holdings of these bonds as short-term yields turned negative, yet corporate lending remained sluggish, largely due to Japan's vertical investment–saving (IS) curve. This situation underscores the need for positive investment returns and corporate willingness to invest, which the current low interest rates have not sufficiently addressed. Japan's prolonged recession is attributed to structural issues beyond the reach of its existing monetary policies.

Most economists surveyed by Reuters expect the BOJ to hold its current course this month, with a potential rate hike more likely in September or October. However, the outcome of the July 30-31 meeting remains uncertain. The decision is considered close and difficult, with differing opinions on whether action should be taken immediately or postponed.

Although there is general agreement among the nine-member board on the necessity of a rate hike, there is no clear consensus on the timing. With core inflation reaching 2.6% in June and a significant increase in workers' base pay in May, there is strong support for a rate increase now. However, recent weak consumer spending and low household confidence have led some board members to advocate for waiting to see the effects of tax cuts and rising wages on consumption.

The BOJ is likely to implement a rate hike soon, but the exact timing is still uncertain. Governor Kazuo Ueda has stated that the central bank will raise rates if economic and wage growth support maintaining inflation near the 2% target in the coming years. Despite rising consumer prices since the COVID-19 pandemic, avoiding persistent deflation—a recurring issue in Japan over the past three decades—remains a crucial concern.

Following the recent end of its negative interest rate policy in March, the BOJ currently maintains short-term rates near zero. The anticipated rate increase is expected to initiate a tightening cycle, gradually moving rates to a neutral level, estimated between 0.5% and 1.5%, a process that could span several years. Even with this hike, Japan's monetary conditions will likely remain relatively loose for some time.

In addition to the rate decision, the BOJ will outline a quantitative tightening strategy during this month’s meeting, detailing how it will reduce its substantial bond purchases over the next one to two years. The central bank plans to shrink its nearly $5 trillion balance sheet while avoiding significant disruptions in bond yields. The BOJ is expected to cut its monthly bond purchases by half during this period, in line with market expectations to prevent abrupt spikes in yields. This marks a significant departure from the aggressive stimulus measures of the past eight years.

The Bank of Japan’s potential move to raise interest rates and cut bond purchases is likely to have a notable impact on the Japanese yen. Typically, an increase in interest rates makes a currency more appealing to investors due to the higher returns on investments it offers. Thus, if the BOJ decides to raise rates, the yen could strengthen as investors flock to Japan to capitalize on the improved yields. Similarly, the reduction in bond purchases, known as quantitative tightening, could also lead to higher bond yields, making Japanese assets more attractive and further boosting the yen.