"Inflation Risks May Stir BOJ Discussion of Rate Hike in May"

The Bank of Japan (BoJ) is facing a critical juncture as inflation risks loom large, potentially stirring discussions about a rate hike in May. The BoJ's decision to raise the short-term policy rate from 0.25% to 0.5% has already sent ripples through the market, with the Japanese Yen strengthening against the US Dollar. This move is part of a broader strategy to control inflation, which has been a persistent challenge for Japan.



The BoJ's decision to raise rates is aimed at controlling inflation, which has been a concern globally. In Japan, inflation has been relatively low compared to other G7 countries, but recent data shows an increase. For instance, inflation in Japan was below desirable levels for decades, including episodes of actual deflation. In response, the Bank of Japan tried various policies to raise inflation, including the adoption of a formal 2% inflation target in 2013. However, none of those efforts succeeded in achieving a persistent rise in inflation (see Christensen and Spiegel 2019 for a review). Since spring 2022, though, there has been a notable and seemingly lasting increase in Japanese inflation. Moreover, there are tentative signs that inflation expectations in Japan may have moved up in response to the spike in inflation. For example, surveys indicate that professional forecasters have lifted both their short-term forecasts for inflation in 2024 and their long-term expectations for average inflation over the coming decade. This upturn in inflation and measures of expected inflation coincides with a booming stock market—Japan’s Nikkei index recently surpassed its previous 1989 all-time high—suggesting investor optimism. At the same time, though, measures of economic growth over the last couple of quarters have been disappointing, which may reflect declining economic momentum. Given Japan’s difficulty escaping its long history of undesirably low inflation, the sustainability of the recent upturn remains in question. In thisEconomic Letter, we turn to Japanese bond markets to produce market-based estimates of investors’ expectations for future inflation using a novel model of nominal and real Japanese government bond yields described in Christensen and Spiegel (2024). Our yield curve model is the first to account for liquidity risk in real yields while also adjusting for inflation and deflation risk premia. Our results indicate that long-term inflation expectations have increased over the past couple of years, above levels indicated by recent survey data. However, our model projections suggest that further increases are less likely and that long-term expectations for future inflation will remain anchored below Japan’s 2% inflation target. Recent inflation developments in Japan Consumer price index (CPI) inflation in Japan has been well below the 2% target adopted by the Bank of Japan in 2013 for much of this century. This has included several periods of declining prices, such as during the Global Financial Crisis and the COVID-19 pandemic (Figure 1). Figure 1 Japanese CPI inflation Source: Bloomberg. The increase in inflation since spring 2022 may have changed Japanese inflation dynamics in a lasting way. One noticeable change is that inflation has remained elevated for several months. Also, there are early signs that inflation expectations in Japan may have started to respond. Figure 2 shows that professional forecasters surveyed by Consensus Economics have progressively lifted their monthly responses for the short-term inflation outlook for 2024, reflected in the median projection (solid blue line) and range of forecasts (dashed blue lines). Perhaps more importantly, they also raised their long-term expectations for average inflation over the next 10 years. These are reported every six months and are shown as a green data point for the 10-year forecast as of each corresponding survey date. Figure 2 Short-and long-term Japanese CPI inflation forecasts Note: Forecasts as of corresponding survey dates for 2024 (blue lines) and 2034 (green data points). Source: Consensus Economics Given Japan’s history of unsuccessful attempts at raising inflation, it remains unclear whether recent increases in inflation are likely to be sustained. One risk is that long-term inflation expectations could return to their pre-pandemic lower levels, as has happened in the past. Maintaining long-term inflation expectations that are anchored near the Bank of Japan’s 2% inflation target is likely necessary for achieving and sustaining that target. Using bond pricing to estimate inflation expectations Following our work in Christensen and Spiegel (2024), we generate market-based estimates of expected long-term Japanese inflation. We examine yields for inflation-indexed bonds issued by the Japanese government from January 2005 to the end of March 2024. We also include a sample of Japanese nominal zero-coupon government bond yields from 1995 through the end of March 2024. Japanese inflation-indexed bonds have always protected against inflation by adjusting interest payments, known as coupons, and principal payments to compensate holders for increases in the Japanese Consumer Price Index (CPI).

The potential implications of a rate hike on Japan's inflation expectations are multifaceted, given the country's historical struggle with low inflation and deflation. A rate hike could signal to the market that the BoJ is confident in the economy's ability to sustain higher inflation, potentially anchoring long-term inflation expectations closer to the 2% target. However, it also carries risks, including higher borrowing costs and potential impacts on consumer spending and economic growth. The market's reaction and the BoJ's future policy actions will be crucial in determining the long-term implications of this rate hike.

The BoJ's decision to raise rates could have a significant impact on the Japanese Yen's exchange rate and, consequently, on Japan's export-driven economy. A stronger Yen can make Japanese exports more expensive for foreign buyers, potentially reducing demand for Japanese goods. This is a critical concern for Japan, as exports account for a significant portion of its GDP. Conversely, a stronger Yen can make imports cheaper, which could benefit Japanese consumers and businesses that rely on imported goods. However, this could also lead to increased competition for domestic producers, further impacting the export sector.

In conclusion, the BoJ's potential rate hike in May has the potential to influence inflation expectations positively by signaling the BoJ's confidence in achieving its 2% inflation target. However, it also carries risks, including higher borrowing costs and potential impacts on consumer spending and economic growth. The market's reaction and the BoJ's future policy actions will be crucial in determining the long-term implications of this rate hike.