Will the Bank of Japan take a more "hawkish" stance with interest rate hikes and balance sheet reduction?

Author: Zhao Ying, Wall Street Journal

The Bank of Japan has taken a "hawkish" turn, announcing interest rate hikes and balance sheet reduction, demonstrating its determination for policy normalization.

On Wednesday, July 31, the Bank of Japan announced its latest interest rate decision, raising rates by 15 basis points to a policy rate of 0.15%-0.25%. The decision was passed with a 7-2 voting ratio, while the market had previously expected no change.

At the same time, the Bank of Japan announced a balance sheet reduction plan, decreasing the scale of government bond purchases by 400 billion yen each quarter, and will no longer provide a range for bond purchases but rather a specified amount. The Bank of Japan unanimously voted to reduce the scale of bond purchases, but this was less than the previously expected monthly reduction of 1 trillion yen.

The new monetary market operation guidelines will take effect on August 1, 2024. Analysts believe:

The Bank of Japan pointed out that inflation risks are tilted to the upside for the next two years, which may be the reason for its actions. If this outlook proves correct, the Bank of Japan may further raise interest rates.

After the announcement, the yen experienced sharp fluctuations against the dollar, currently falling below 153, having briefly surged past the 152 mark earlier. The Nikkei 225 index continued to decline after the Bank of Japan's decision, while the futures for Japan's 10-year government bonds narrowed their intraday losses following the interest rate announcement.

"Unexpected" Rate Hike, Balance Sheet Reduction "Below Expectations"

The Bank of Japan's "unexpected" rate hike came as the market had only anticipated about a 40% chance of a hike in July; however, the balance sheet reduction was below expectations, with the market generally expecting the purchase amount to decrease to 5 trillion yen next month. Bank of Japan Governor Kazuo Ueda had previously emphasized that the reduction would be quite significant.

Specifically:

The current monthly bond purchase scale is about 6 trillion yen, with the July monthly purchase scale at approximately 5.7 trillion yen. From August to September, the monthly purchase scale will be around 5.3 trillion yen, and from October to December, it will be about 4.9 trillion yen…

By the first quarter of 2026, the monthly purchase scale is expected to be around 3 trillion yen, and Japan's government bond holdings are projected to decrease by about 7-8% by mid-2024.

The Bank of Japan added that a 0.25% interest rate applies to the balances of current accounts held by financial institutions at the Bank of Japan; it will reduce government bond purchases in a predictable manner, announcing the bond purchase scale each quarter and adjusting the bond purchase plan as needed. A mid-term assessment of the bond purchases will be conducted in June 2025, and if necessary, the bond purchase plan will be evaluated at policy meetings.

It is worth mentioning that prior to the announcement, Japanese media had "leaked" information, with NHK, Nikkei, and Jiji Press pointing out the possible rate hike by the Bank of Japan. The bond purchase schedule for August to September was also announced as expected, with the purchase amounts reduced compared to before.

Price Risks Tilted Upward, Further Rate Hikes Possible

The Bank of Japan stated:

With substantial changes in the economic outlook, it will adjust its accommodative policy, as real interest rates are significantly low.

If the inflation outlook materializes, it will continue to raise rates, with wage increases significantly higher than last year, and inflation risks for the fiscal years 2024 and 2025 are tilted to the upside.

In terms of inflation forecasts, the Bank of Japan slightly lowered the core CPI for the fiscal year 2024/25, while keeping the core CPI excluding energy unchanged:

The core CPI for the fiscal year 2024 is 2.5%, down from the previous forecast of 2.8%; the core CPI for the fiscal year 2025 is 2.1%, up from the previous forecast of 1.9%; the core CPI for the fiscal year 2026 remains at 1.9%, unchanged from the previous forecast.

The core CPI excluding energy for the fiscal year 2024 is 1.9%, unchanged from the previous forecast; the core CPI excluding energy for the fiscal year 2025 is expected to be 1.9%, unchanged from the previous forecast; the core CPI excluding energy for the fiscal year 2026 is expected to be 2.1%, unchanged from the previous forecast.

At the same time, Japan also stated:

The yen exchange rate is more likely to affect prices than before, with import prices rising again, and there must be vigilance against the risk of inflation overshooting.

Moreover, despite the impact of prices, private consumption remains resilient, and recent corporate behavior is gradually shifting towards raising wages and prices.

The accommodative monetary policy environment will continue to support the economy, and real interest rates are expected to remain significantly negative.

Will the Bank of Japan Become More "Hawkish"?

Analysts believe that this interest rate decision is not dovish. The Bank of Japan has committed in writing that if the positive conditions for economic activity and inflation outlook continue, it will further raise rates. This is the first time, and it reflects the hawkish stance of the Bank of Japan under Governor Kazuo Ueda. Regarding the scale of bond purchases, ATFX Global Markets analyst Nick Twidale believes that the reduction in bond purchases by the Bank of Japan is far below expectations, which has heavily impacted the yen.

However, analysts Toru Fujioka and Sumio Ito believe that the yen's weakness has reached a turning point:

The Bank of Japan has raised its policy rate and indicated that it will reduce the monthly bond purchase pace to about 3 trillion yen by the first quarter of 2026. Governor Kazuo Ueda, while taking these measures, has also expressed the bank's willingness to continue advancing the normalization process. Wednesday's actions may fuel speculation that there could be another rate hike this year. Just hours before the Federal Reserve's upcoming meeting, the Bank of Japan's hawkish leanings could signify a turning point for the struggling yen, as traders believe the interest rate gap between Japan and the U.S. will narrow. Any hints from the Federal Reserve about a possible rate cut in September would support this notion.

Izuru Kato, chief economist at OTAN Research, stated:

The decision to raise rates is likely aimed at correcting the overly accommodative monetary policy, reflecting that the actual policy rate has deeply entered negative territory. Although the Bank of Japan has consistently explained that monetary policy is not aimed at the currency, the weakness of the yen has certainly been a significant factor behind today's decision, as it has impacted small and medium-sized enterprises in rural Japan. The magnitude of the rate hike is small and merely symbolic. There is no need to worry about a faster pace of rate hikes, as the increases in March and July only reached the level of a typical central bank's one-time hike. This does not mean that the Bank of Japan has suddenly turned hawkish. Looking ahead, the Bank of Japan will remain cautious and avoid tightening policy too hastily.