Japan's Central Bank Expected to Hold 0.5% Rate Amid Political Shifts

Japan's central bank is expected to maintain its 0.5% benchmark interest rate this week, as the political landscape in the country shifts following the announcement of the Prime Minister's intention to step down. The market consensus, based on a survey of 50 economists, is that the two-day policy meeting ending on Friday will result in no change to the interest rate. Central bank officials are reportedly assessing the impact of U.S. tariffs on both domestic and global economies.

The focus has now shifted to the possibility of a rate hike in October, with over a third of respondents predicting an increase to 0.75%. The central bank's independence is emphasized, but political changes and the Federal Reserve's rate decisions could still influence its decisions. The potential for a U.S. rate cut and fluctuations in the yen's exchange rate are also being closely monitored, as a weakening dollar could strengthen the yen and impact Japan's export-driven economy.

Despite the political instability, central bank officials believe that a rate hike before the end of the year is still possible if economic data meets expectations. Since late July, following trade talks between the U.S. and Japan, the U.S. has signed an executive order reducing auto tariffs to 15%. Economic data has been robust, with revised GDP exceeding expectations and key inflation indicators remaining above the 2% target for over three years, supporting the case for a rate hike.

However, the political uncertainty has intensified following the Prime Minister's resignation, as the ruling coalition lacks a majority in both houses of parliament. The new leader of the Liberal Democratic Party, to be elected on October 4, may face challenges in forming a cabinet. If the new leader is someone who has previously warned against "premature rate hikes," the process could be delayed. Several institutions, including French banks and Barclays, have pushed back their rate hike expectations for October.

Historically, coordination between the central bank and the government has shown that policy disagreements can lead to conflicts during economic normalization. However, since the large-scale easing in 2013, these concerns have been alleviated. Currently, the central bank is closely monitoring the possibility of a soft landing for the U.S. economy and the risk of weakening employment data. The sustainability of corporate profits and wage growth is crucial.

If the world's largest economy slows down more than expected, Japanese corporate profits will be under pressure, suppressing wage growth and breaking the positive inflation cycle. The pace of the Federal Reserve's rate cuts directly affects the yen's trajectory: rapid appreciation exacerbates corporate profit declines, while excessive depreciation could drive up import inflation, forcing the central bank to accelerate rate hikes. Last week, finance ministers from the U.S. and Japan reiterated that they would not seek competitive advantages through exchange rates, with some analysts interpreting this as a hint from the U.S. that Japan should use rate hikes rather than intervention to correct yen weakness.

This week, the central bank's policy statement is expected to remain largely unchanged, with the focus on the press conference by the Governor. A former central bank official noted that the Governor needs to balance dovish and hawkish statements—being too dovish could lead to yen depreciation, while being too hawkish could shock the market. A survey indicated that more than half of the observers believe that the Governor tends to be dovish when maintaining rates and hawkish when raising them. On October 3, the Governor is scheduled to deliver a significant speech, which may hint at whether action will be taken during the October 29-30 meeting.

Another strategist suggested that the next rate hike could be as early as December, with the baseline scenario being January. The urgency for the central bank to act has decreased as expectations for a Federal Reserve rate cut have been partially priced in.