Further yen weakness could force the Bank of Japan to hike earlier
The Bank of Japan (BoJ) kept its policy rate at 1% at Friday’s meeting, as expected. We continue to project that the central bank will hike in December after assessing the impact of the June rate hike, as requested by the government. But a rate hike in October is possible, especially if the yen depreciates further.
The BoJ’s quarterly projections continue to show that underlying inflation will rise gradually to reach the 2% inflation target in H2 of fiscal year 2026 and in fiscal year 2027 (Q4 2026-Q1 2028), indicating that the BoJ will continue to normalise interest rates. The bank also stressed that the risk of inflation overshooting its 2% inflation target is non-negligible and could exert lasting negative impact on the economy.
The BoJ will likely keep hiking gradually to assess the impact on the economy and financial conditions, given that the policy rate approaches the bottom of a wide range of estimates for a neutral rate. The government has become increasingly concerned about the negative impact of rate hikes on the vulnerable parts of the economy.
A major risk to our policy outlook is the yen. Unless the BoJ contains the perception that it is falling behind the curve in fighting inflation, a depreciation in the yen together with higher oil prices could aggravate the terms-of-trade shock, raising the risk of the economy falling into stagflation. Faster rate hikes may support the yen but would be negative for the economy, which is structurally vulnerable to the terms-of-trade shock.
