BOJ Weighs Rate Hike Amidst Political Shifts in Japan

Bank of Japan officials believe another increase in the benchmark interest rate is possible this year, regardless of domestic political turmoil, as economic conditions are developing as expected, according to sources familiar with the matter. The sources indicate that the U.S.-Japan trade agreement has eliminated a key source of uncertainty, but the BOJ is likely to keep its rate at 0.5% at its next policy-setting meeting on September 19, as officials are still assessing the economic impact of U.S. tariffs both domestically and internationally. The BOJ is scheduled to hold further policy meetings in October and December of this year. The announcement of this news accelerated the decline of the U.S. dollar against the Japanese yen, extending intraday losses to 0.6%.

Political Uncertainty and Potential Impact

The decision by Japanese Prime Minister Shigeru Ishiba to resign earlier this week has cast a shadow over the future of Japanese politics and government policies, which could give the BOJ further reason to slow the pace of its next rate hike, especially if the next leader is concerned about borrowing costs rising too quickly. Some economists warn that moves aimed at bolstering popular support could disrupt the fiscal discipline of the ruling coalition. Three sources familiar with the BOJ's thinking stated that the broader political uncertainty would not derail the BOJ's plans to continue gradually raising interest rates, but it could affect the timing of the next increase. "The BOJ doesn't need to raise rates in a turbulent time," one of the sources said. "It's not in a hurry and is free to decide when to raise rates, as long as it raises them again by early next year." Officials believe the bank is making progress towards raising rates again after the January hike. Some sources said that some officials even believe that raising the rate as early as October might be appropriate.

Economic Data Supports Rate Hike

Japan's revised GDP report this week confirmed that the economy continues to grow moderately. In this context, overall corporate profits in the last quarter hit record highs, and the labor market remained tight, putting upward pressure on wages throughout the industrial sector. In July, real wages turned positive for the first time in seven months, and even the minimum wage is expected to record its largest increase on record this year.

Monitoring Economic Data

Sources said that reviewing economic data and information in the coming months will be crucial, especially after the U.S.-Japan trade agreement, as the bank may then be able to judge whether economic conditions are appropriate for a rate hike. These views are somewhat at odds with the market's changing perceptions. Following news of Shigeru Ishiba's resignation, overnight swap market pricing showed on Tuesday that the probability of the BOJ raising interest rates before the end of the year was about 50%, down from about 70% at the beginning of the month.

The Future of Japanese Politics Matters

The frontrunner to become the country's next prime minister, Sanae Takaichi, is reportedly going to participate in the Liberal Democratic Party leadership election in October and is a staunch supporter of the "Abenomics"-style fiscal and monetary stimulus policies introduced by the late Prime Minister Shinzo Abe. She stated last September that raising interest rates at the time was "absurd." With the market pricing in a possibility of her winning, and with the potential for increased fiscal spending regardless of who wins, Japanese corporate stocks rose this week, and super-long bond yields remained near record highs. Another contender is Shinjiro Koizumi, who advocates deregulation, but his views on monetary policy are largely unknown.

Impact of New Government Policies

Sources said that BOJ officials will monitor signals sent from the new government, particularly the potential commitments to economic measures and how those steps might impact economic growth, inflation, and financial markets. They said inflationary pressures could rise, depending on the amount of new spending, which could affect the timing of the next interest rate increase. Analysts say that even if Takaichi wins, she may need to use rising inflation to temper calls for ultra-low interest rates, rather than the risk of deflation, which has now become a bigger problem facing the public. "Support within the LDP for lawmakers advocating reflationism has declined," said Ryutaro Kono, chief Japan economist at BNP Paribas. "Therefore, Takaichi needs to curb her calls for reflationary policies to some extent in order to gain widespread support within the party."

Monitoring the U.S. Economy

Sources said the BOJ is also closely monitoring the direction of the U.S. economy, including whether it will achieve a soft landing after recent jobs data sparked growing concerns. Last week, a speech by Deputy Governor Ryozo Himino was interpreted as dovish by traders. Some sources said some officials interpreted his policy stance in the speech as neutral.