Political Turmoil Clouds Japan’s Monetary Outlook

The Japanese yen has continued to weaken against major currencies, driven by structural economic factors and increasing political uncertainty. Recent data shows that Japan’s second-quarter GDP expanded by 0.5% on a quarter-on-quarter basis, stronger than the initial 0.3% estimate. This growth, attributed primarily to private consumption and net exports, has not been enough to solidify expectations for a Bank of Japan (BoJ) rate hike in the near term. Political instability, including the recent resignation of Prime Minister Shigeru Ishiba, has further clouded the outlook for monetary policy and deepened concerns about the yen’s performance [1].

Private consumption has remained a key pillar of Japan’s economic resilience, growing for five consecutive quarters. However, non-residential investment fell short of expectations, revised down to 0.6% from an initial 1.3% flash estimate. The inventory contribution to GDP also played a role in the upward revision, with adjustments in the inventory contribution increasing by 0.0 percentage points. Analysts suggest that the strong export performance in the second quarter is unlikely to persist, as recent shipments may have been front-loaded, leading to a more pronounced technical correction in the current quarter [1].

Structural challenges, including stricter construction regulations and a less favorable inventory cycle, are expected to weigh on growth in the coming months. Despite these headwinds, private consumption is forecast to remain robust, supported by continued wage growth and moderate inflation in key sectors like food and energy. Fiscal stimulus is also expected to play a role in sustaining domestic demand, particularly in the second half of 2025. These factors have led to an upward revision of Japan’s 2025 GDP forecast to 1.1% from 0.9% [1].

Political uncertainty remains a significant overhang for both the yen and Japan’s broader financial markets. Following Ishiba’s resignation, Japanese government bond futures rose, and concerns over the country’s fiscal outlook are growing. The upcoming leadership transition within the Liberal Democratic Party is expected to influence macroeconomic policy direction, although the lack of a clear majority for the party may limit the scope for major fiscal or monetary reforms. Two leading candidates for the prime ministerial position have distinct policy approaches—one favoring fiscal expansion and accommodative monetary policy, the other advocating for structural reforms and a neutral stance on monetary normalization [1].

From a monetary policy perspective, the probability of a rate hike by the end of the year has declined. The overnight indexed swap (OIS) now implies a 43% chance of a BoJ rate hike by year-end, down from 70% the previous week. Despite strong first-half growth and inflation above 2%, analysts remain cautious. The Bank of Japan Working Paper Series and related research underscore ongoing complexities in the implementation of monetary policy, particularly in the context of negative interest rates and the long-term effects of accommodative measures [2]. These studies highlight the challenges the BoJ faces in balancing inflation control with economic stability.

Source:

[1] Solid Japanese GDP not enough to ensure BoJ rate hike | snaps (https://think.ing.com/snaps/japan-stronger-than-expected-gdp-vs-rising-political-uncertainty/)

[2] Bank of Japan Working Paper Series (https://www.boj.or.jp/en/research/wps_rev/index.htm)