Bank of Japan officials have indicated a willingness to raise interest rates more rapidly than the market's general expectation if inflation risks persist, solidifying the prospect of another hike within the year.
According to media reports on the 22nd citing informed sources, while most economists anticipate the next move in December, central bank officials have clarified there is no predetermined path and action could be taken before the six-month window if necessary. The recent slide of the yen to its weakest level in about four decades poses fresh inflationary pressures, heightening officials' vigilance. Overnight index swap data shows markets are now pricing in roughly a 72% chance of another rate hike by October.
These signals prompted an immediate reaction in the Japanese government bond market. The yield on 2-year JGBs rose to its highest level since 1995 on Wednesday, while the 5-year yield climbed to 1.995%. Concurrently, the yen strengthened from around 163.13 to 162.69 per US dollar.
Inflation Nears Target, Prompting Policy Shift
The core factor driving officials' openness to a faster pace of hikes is that Japan's underlying inflation rate is increasingly approaching the 2% target set by the central bank over thirteen years ago, according to the report's sources.
Officials have noted that companies are accelerating the pace at which they pass on costs downstream, a shift in pricing behavior closely linked to market conditions following the outbreak of conflict in Iran. In this context, renewed yen weakness could further incentivize firms to raise prices.
Notably, officials' understanding of their policy task is also subtly evolving—the focus is shifting from "pushing inflation higher" to "ensuring inflation is stably anchored near the target." This logical shift implies authorities have sufficient reason to act preemptively, even before inflation exceeds the target.
Yen Weakness and Fiscal Concerns Limit Intervention Scope
The recent pressure on the yen is particularly noteworthy. After the yen fell to its weakest level in about forty years overnight, the Japanese government issued a warning of potential intervention. However, Jumpei Tanaka, Head of Investment Strategy at Pictet Asset Management Japan Ltd., pointed out that "as market concerns about expansionary fiscal policy intensify, the scope for currency intervention alone to suppress yen depreciation may be increasingly limited."
In response, Bank of Japan officials continue to emphasize that monetary policy is not aimed at a specific exchange rate level but acknowledge that the impact of yen fluctuations on prices warrants close attention. Yen depreciation, by pushing up import costs, could further fuel inflation, creating more direct pressure on the rate hike path.
Market Pricing Outstrips Economists, No Change Expected at Next Meeting
A significant divergence has emerged between market and economist expectations. A survey of economists conducted before the June 16 rate hike showed about 70% of respondents expected the Bank of Japan's hiking pace to be around once every six months. In contrast, market participants have already positioned for a faster pace, with overnight index swaps currently implying about a 72% probability of another hike before October.
In the near term, markets widely expect the Bank of Japan to keep policy unchanged at its board meeting on July 31st. The bank just raised its benchmark rate to 1% last month, the highest level in 31 years. Informed sources indicate officials will closely scrutinize subsequent inflation risks and retain the flexibility to adjust the pace at any time.
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