The BOJ's Dilemma

 

As the Federal Reserve aggressively cuts interest rates by 50 basis points to begin a rate-cutting cycle, with the Bank of England, the European Central Bank, and the Bank of Canada all entering a rate-cutting cycle, the Bank of Japan's interest rate decisions are particularly under scrutiny.

Since 2016, the Bank of Japan has maintained a negative interest rate, a stance that only began to shift earlier this year. In March of this year, the Bank of Japan decided to raise short-term interest rates from the previous -0.1% to 0-0.1%, marking the first rate hike in Japan in 17 years. Subsequently, in July, it further raised the key short-term interest rate to 0.25%, the highest level since 2008. Therefore, the market is closely watching whether it will raise rates further in September.

On September 20th, the Bank of Japan announced that it would maintain the interest rate at 0.25%, in line with market expectations. In its statement, the central bank expected inflation to continue to rise, with a virtuous cycle between wages and prices expected to continue to strengthen. However, regarding the outlook for risks, there is still considerable uncertainty surrounding economic activity and prices in Japan, including the development of overseas economic activity and prices, the development of commodity prices, and the wage and price-setting behavior of domestic companies.

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For the next interest rate adjustment, the Bank of Japan stated that it is necessary to pay appropriate attention to the development of financial and foreign exchange markets and their impact on Japan's economic activity and prices. In particular, as corporate behavior has recently shifted more towards raising wages and prices, exchange rate developments are more likely to affect prices compared to the past.

 

Why has Japan maintained negative interest rates for such a long period?

For a long time, Japan has used negative interest rates to stimulate the economy and combat deflation. Japan has maintained extremely low interest rates since the 1990s. The Bank of Japan decided to implement a zero interest rate policy in 1999, and since then, short-term policy interest rates have been at an extremely low level, except for the period from 2006 to 2008 (during which the policy interest rates were also low but at least positive, ranging from 0.25% to 0.5%). After the global financial crisis, interest rates returned to near-zero levels.

Japan's ultra-low interest rates reflect the fact that the Japanese economy has experienced long-term growth stagnation and persistent deflation over the past 20 years, possibly due to: 1) the traumatic impact of the bursting of economic and real estate bubbles in the 1990s on the entire society; 2) population decline and aging; 3) the rapid development of emerging economies, bringing a large number of cheap imported products. These factors have exerted tremendous downward pressure on Japan's economic growth and inflation.

In this environment, small non-manufacturing companies have maintained their businesses by cutting costs, such as hiring more non-regular workers. This strategy can maintain domestic economic performance, but it is a fatal mistake for future growth, as it is not conducive to business innovation and value creation, and the economy has fallen into a cycle of low wages and low prices. This situation has only recently begun to change.

 

How has the Bank of Japan changed its stance?

Zero interest rates are not a universal strategy for driving the economy. When wage levels fail to keep up with price increases, consumers tend to reduce spending, which only stagnates or even reverses economic growth. Moreover, long-term zero or negative interest rates have also put the Bank of Japan in a passive position in using monetary policy to regulate the economy.

After the pandemic, global inflation and pent-up consumer demand have led to cost-push inflation, a problem that Japan also faces. This, in turn, has pushed up nominal wages, and the government and several major industry associations have strongly called for wage increases, providing the Bank of Japan with the confidence to advance the normalization of monetary policy.

On the other hand, although Japan is an export-oriented country, it also needs to import natural gas, oil, and other necessities. The continuous interest rate hikes in major developed countries in Europe and America, along with the widening interest rate gap with Japan, have put heavy pressure on the yen exchange rate. This has also provided opportunities for yen short sellers in the capital market, with a large number of short-selling transactions causing the yen exchange rate to continue to decline.

See the chart below, the yen exchange rate against the US dollar once fell below the 160 yen level.

With the decline in the yen exchange rate, the price of Japan's imported necessities has also become extremely expensive, which is also an important reason for the surge in Japan's inflation rate. In addition, the increase in foreign tourists entering Japan has also driven up local prices.

See the chart below, since this year, Japan's core inflation rate has risen, with the annual increase above 2.2% since February, higher than the Bank of Japan's core inflation target of 2%, further supporting the Bank of Japan's shift in attitude. This is the reason why the Bank of Japan has shifted from negative interest rates to positive interest rates.

 

What is the future stance of the Bank of Japan?

In the monetary policy statement released by the Bank of Japan on September 20, it pointed out that: the Japanese economy has seen a moderate recovery, but some industries are still weak. The overall overseas economy has seen moderate growth. Exports and industrial output are roughly flat. With improving corporate profits, business investment is rising moderately. Employment and income conditions are moderately improving.

Although affected by rising prices and other factors, private consumption is growing moderately, but residential investment remains relatively weak. Public investment is roughly flat.

From the perspective of prices, the consumer price index (CPI) has recently been in the range of 2.5%-3.0% year-on-year, mainly due to the continuous rise in service prices, mainly due to wage increases. However, the transmission effect of past import price increases on consumer prices has weakened. Inflation expectations are slowly heating up.

In August 2024, the core consumer price index, excluding fresh food but including energy costs, rose by 2.8% year-on-year, which is also the highest level since February, higher than the previous month's 2.7%.

The Japanese economy may continue to grow at a rate higher than the potential growth rate, with overseas economies continuing to grow moderately, and against the backdrop of a loose financial environment, the virtuous cycle from income to consumption is gradually strengthening.

Although the transmission effect of past import price increases on consumer prices will weaken, it is expected that by the fiscal year 2025 (i.e., the fiscal year ending March 2026), the year-on-year growth rate of the CPI (all items except fresh food) will be pushed up by factors such as the weakening of the government's measures to suppress CPI inflation. At the same time, as the output gap is expected to improve, medium and long-term inflation expectations will rise, and the virtuous cycle between wages and prices will continue to improve, so it is expected that the basic CPI inflation will rise gradually.

Regarding the outlook for risks, there is still considerable uncertainty surrounding economic activity and prices in Japan, including the development of overseas economic activity and prices, the development of commodity prices, and the wage and price-setting behavior of domestic companies. In this context, it is necessary to pay appropriate attention to the development of financial and foreign exchange markets and their impact on Japan's economic activity and prices. In particular, as corporate behavior has recently shifted more towards raising wages and prices, exchange rate developments are more likely to affect prices compared to the past.

In simple terms, the momentum of consumer price increases will continue at least until the beginning of 2026. However, the virtuous cycle between wages and prices is expected to further improve, but there are still uncertain risks in domestic economic activity and prices. Therefore, the Bank of Japan will pay attention to the linkage between wages and consumer prices, and will pay attention to exchange rate changes to determine monetary policy. At present, the market generally expects the Bank of Japan to raise interest rates again before the end of this year.

But in any case, this expected maintenance of interest rates has still stirred up the emotions of the capital market.

The yen first rose and then fell. After the announcement of maintaining interest rates unchanged, the yen exchange rate against the US dollar once rose to 142 yen, but it has now fallen, once as low as 143.8, now reported at 143.63 yen, see the chart above.

Japanese stocks also performed well, with the Nikkei 225 index closing up 1.53%, reporting 37,723.91, up 12.73% year-to-date, outperforming the Dow Jones Industrial Average (DJI.US) by 11.50%. Among them, the most active transactions were semiconductor testing equipment manufacturer Lasertec (6920.T), precision processing equipment supplier DISCO (6146.T), Uniqlo's parent company Fast Retailing (9983.T), and Tokyo Electron (8035.T), an important manufacturer in the semiconductor upstream supply chain, with single-day increases of 4.78%, 2.37%, 4.16%, and 5.32%, respectively.

 

The dilemma faced by the Bank of Japan

Compared with the Federal Reserve, the Bank of Japan is in a more difficult position: if it raises interest rates, it may extinguish the hard-won signs of economic improvement; if it does not raise interest rates, despite the Federal Reserve's rate cuts, there is still a significant gap with Japan's current interest rates, creating a large arbitrage space, which may exacerbate inflation and add to the already fragile enterprises.

The Japanese parliament will be held in the fourth quarter, which will have a significant impact on the yen exchange rate and the economy, and will inevitably affect the Bank of Japan's attitude and orientation. This is also an important reason for its inaction in September, and it is estimated that its decisions will be influenced by many factors in the future.