What's next for the Bank of Japan? HSBC has given a roadmap

On April 24, Frederic Neumann, chief Asia economist at HSBC Global Research, released his latest research report titled "What's Next for the Bank of Japan?".

He pointed out in the research report that if inflation expectations continue to rise, the Bank of Japan can theoretically raise interest rates by raising nominal interest rates while real interest rates remain unchanged.

However, as the downside risks to Japan's growth remain considerable, the BOJ's policy tightening needs to be gradual to help the economy adapt to a positive interest rate environment, and not rush to avoid too large a shock to the economy and consumption. Of course, Japan's interest rate policy also depends in part on changes in interest rates in other regions, such as the United States. If U.S. interest rates remain high for an extended period of time, the Bank of Japan may raise rates more quickly.

As a result, we forecast that the Bank of Japan will raise the policy rate ceiling from 0.10% to 0.25% in the third quarter of 2024. Thereafter, it is expected to raise rates by another 25 basis points to 0.50% in the first quarter of 2025 and a further 25 basis points to 0.75% in the third quarter of the same year.

In addition, we have raised our 2025 core CPI forecast for Japan to 2.2% from 1.9%, taking into account Japan's strong wage growth and services inflation.

How fast can the Bank of Japan raise interest rates?

Japan's economy appears to be emerging from a prolonged deflationary woes, and faster wage growth and rising inflation expectations suggest that Japan may have begun to enter a virtuous cycle that will allow the Bank of Japan to eventually normalize policy.

A key question is: how quickly can the BOJ raise interest rates without disrupting the reflation process?

On the one hand, Neumann said that if policy tightens too quickly, it could lead to a stronger yen, thus offsetting the previous inflationary push through the yen's depreciation:

There are two main sources of reflation in Japan:

The first is the change in the labor market, where wages are starting to rise due to labor shortages.

The second is the depreciation of the yen, which has led to an increase in the cost of imports, which has pushed up inflation while also boosting demand for goods and tourism.

The second source has already hinted that the Bank of Japan must be careful when considering policy adjustments. If policy tightens too quickly, it could lead to a rise in the yen, offsetting the previous inflationary push through the yen's depreciation.

On the other hand, the Bank of Japan needs to be very cautious when considering raising interest rates, and must weigh the extent to which this decision will affect different economic groups in order to avoid an excessive shock to the economy and consumption:

First, the tightening will affect both borrowers and savers. If interest rates rise, borrowers (such as mortgage borrowers) will need to pay more interest on their loans, which means that their debt expenses will increase, and savers with deposits will receive higher 'income' as interest income increases.

As a result, consumer spending is influenced by three factors: (1) wage growth, (2) the ratio of indebted households to indebted households, and (3) the propensity of debtors and savers to spend.

The uncertainty of all these factors requires the Bank of Japan to be cautious. The Bank of Japan (BOJ) needs to move forward with policy gradually so that the distributive consequences of rising nominal interest rates do not 'shock' consumption.

Second, public debt is also a factor to consider. For example, a rapid rise in interest rates could lead to an increase in the yield on government bonds, which would increase the government's interest expense. This effect will be felt as more and more debt matures and needs to be refinanced. This may require governments to reprioritize public spending and reduce spending on investments and other government services, which could adversely affect GDP growth, especially if domestic government bond investors do not use the additional interest income they receive for consumption.

In extreme cases, a sharp rise in government financing costs could also jeopardize public finances, which could limit the BOJ's willingness to tighten policy quickly.

Of course, there are some mitigating factors, such as rapid growth in nominal GDP that will slow the rise in debt-to-GDP ratio, and Japan's tax elasticity (the ability of tax revenues to increase with economic growth) is good, helping to speed up the pace of tax collection.

In addition, Japan's interest rate policy depends in part on interest rate changes in other regions, such as the United States. If U.S. interest rates remain high for an extended period of time, the Bank of Japan may raise rates more quickly.

How big will the Bank of Japan raise interest rates in the future?

Neumann noted that given that downside risks to growth remain considerable, the BOJ will need to gradually raise interest rates to minimize disruption and help the economy adapt to a positive interest rate environment.

According to forecasts, the BOJ will raise its policy rate ceiling target from 0.10% to 0.25% in the third quarter of 2024, then another 25 basis points to 0.50% in the first quarter of 2025, and then another 25 basis points to 0.75% in the third quarter of the same year (which is still well below the neutral nominal rate, of course). This path takes into account the SME wage growth cycle and its timing of its reflection in macro data.

Neumann noted that, on the one hand, if inflation expectations continue to rise, the BOJ could theoretically raise the nominal interest rate (i.e., the announced interest rate) if the real interest rate (the interest rate after inflation) remains unchanged. For now, inflation expectations seem likely to stabilize at around 2%, which means that the BOJ can raise interest rates by about 150 basis points (bringing real rates close to its long-term average of around -0.5%) without causing too much damage to the economy.

While it is theoretically possible to raise interest rates, the practice will be more complicated. For an economy that has maintained extremely low interest rates for a long time, once the Bank of Japan raises nominal interest rates, this could have some devastating effects on the economy. This is because changes in interest rates affect the cost of borrowing, people's consumption, and companies' investments, among other things.

Of course, if economic growth improves, such as if Japan increases productivity as a result of investing in labor-saving technologies or corporate reforms, then the neutral real interest rate may increase over time (i.e., the level of interest rates that do not promote or inhibit economic growth). However, there is not much conclusive evidence for this yet.

The Japanese economy has entered a new phase of inflation, and the rise in government debt may be manageable

According to Neumann, the risk is that continued monetary policy easing could push inflation up further, causing consumer prices to rise above the BOJ's target, while asset prices continue to climb. On the other hand, in order to ensure the solidity of the reflation process, especially after a long period of sustained deflationary pressures, it is necessary for the Bank of Japan to consolidate the upward trend in inflation expectations. In short, the Bank of Japan is now facing an unprecedented delicate balance.

So far, this policy framework has been relatively straightforward. Complicating matters, however, is the fact that the BOJ's monetary policy stance is influenced not only by the policy rate, but also by the size and composition of the balance sheet. All else being equal, a rapid contraction or expansion of the balance sheet may eliminate the need for faster or slower interest rate adjustments.

For now, the BOJ's guidelines are to keep the balance sheet stable and use interest rate adjustments as the main monetary policy tool. However, this may change over time, for example by adjusting the pace of purchases of government bonds to control volatility in bond yields while smoothing the government's financing operations.

Moreover, the reflation of the Japanese economy suggests that while higher interest rates may increase the cost of future debt repayments (because the interest rate on borrowed money is higher), overall economic growth (i.e., nominal GDP growth) can help partially offset this effect and control the ratio of national debt to gross domestic product (GDP).

At the same time, Japan's long-term tax elasticity coefficient is estimated to be more than 1 (tax elasticity refers to the ability of tax revenues to increase with economic growth). In Japan, when tax elasticity above 1 means economic growth, the proportion of tax increases exceeds the proportion of economic growth. As a result, economic growth can generate more tax revenues and help governments cope with the increased interest burden on debt due to rising interest rates.

All in all, the Japanese economy seems to be in a new inflationary cycle. The Bank of Japan needs to gradually reduce the level of monetary easing in name, but in practice (after accounting for inflation) still needs to remain somewhat accommodative. In the medium term, productivity gains are needed to help the BOJ achieve its neutral monetary policy objective (i.e., a policy state that neither stimulates nor suppresses economic growth), but productivity growth remains elusive and unconvincing.

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