Bank of Japan will continue rate hikes to keep inflation at the target

The Bank of Japan (BoJ) delivered a ‘hawkish pause’ today, keeping its policy rate at 1.25%. This was widely expected and doesn’t alter our near-term forecast. The bank said underlying inflation has already reached the 2% inflation target and stressed that more rate hikes are needed to prevent inflation overshooting. We maintain our call that the BoJ will hike in December and April to a terminal rate of 1.75%.

According to its Quarterly Outlook Report, the economy has been developing in line with the projections set out in the previous report and underlying inflation has reached a level consistent with the 2% inflation target. Governor Kazuo Ueda reiterated that the focus of monetary policy has shifted from raising inflation to 2% to keeping it at the target, given the risks are now tilted to the upside.

Although the BoJ’s favourite indicators for underlying inflation have reached the 2% target, a key driver has been the successful pass-through of a series of external inflation shocks from the supply-side, instead of the wage-driven demand growth that the government and BoJ have pursued. Domestic demand has been resilient to rate hikes and the terms-of-trade shock, but has lacked momentum.

We expect the inflationary shock from higher energy prices and past yen depreciation will gradually fade and that inflation will stabilise around 2% in late 2027. However, if the supply-side shock lasts for longer than we expect, the BoJ may need to hike to 2% by July, just before the terms of the two most hawkish board members end, despite rising pressure from the government.

The central bank decided to increase the annual sales amount of its holdings of exchange-traded funds (ETFs) on the open market from 330 billion yen to 860 billion yen starting in 2027. This will shorten the time required to complete the sales from approximately 112 years to 43 years.