Will the BOJ raise interest rates while the U.S. and Europe cut rates?

Written by Naoya Oshikubo, Chief Market Economist, Mitsubishi UFJ Trust and Banking

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With the U.S. and Japanese elections over and only one month left in 2024, Japanese markets are focusing on the Bank of Japan's monetary policy meeting in December as the next event. With the market now expecting the BOJ to raise its policy rate from around 0.25% to around 0.5% in December or January next year, it will be necessary to reassess the outlook for the BOJ's monetary policy. In this report, we will review the BOJ's recent monetary policy and then consider the outlook.

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At the July 2024 Monetary Policy Meeting, the BOJ raised the policy rate to around 0.25% as the economy and prices were performing well in line with the outlook. However, shortly thereafter, against the backdrop of the abrupt market volatility that occurred in August 2024, BOJ Governor Ueda decided to send a message that no additional rate hike would be made prematurely by using the phrase “there is time to make a decision” regarding an additional rate hike. Subsequently, as markets regained stability and the U.S. economy generally remained strong, at the press conference following the October 2024 Monetary Policy Meeting, Governor Ueda stated that he would no longer use the expression “there is time to make a decision” regarding an additional rate hike in the future. In other words, with regard to the outlook, the Bank will be able to update its assessment of the current situation and outlook for the economy and prices at each Monetary Policy Meeting based on the data and information available at that time, and make policy revisions as appropriate.

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Looking ahead, if overseas economies follow a moderate growth path and wage growth in Japan leads to higher prices, the BOJ will continue to raise interest rates, albeit cautiously, toward a neutral rate (a rate level that neither overheats nor cools the economy). We expect the BOJ to raise the policy rate from about 0.25% to about 0.5% at its January 2025 monetary policy meeting (although an early rate hike in December 2024 is possible, depending on how the yen weakens).

As corporate earnings continue to improve, companies are steadily raising wages against the backdrop of tight labor supply and demand. In addition, companies that have been raising wages have been aggressively passing on the gains to service prices (Exhibit 1), and the virtuous cycle between wages and prices that the Bank of Japan has been targeting has begun to emerge. In recent years, the rise in Japan's CPI has been driven by the rise in import prices due to the weak yen, but as this factor has been slipping away, rising service prices have become the driving force. Looking ahead, there is a strong likelihood that this virtuous cycle will continue. In its basic concept for the 2025 Spring Labor Offensive announced on October 18, 2024, Japanese Trade Union Confederation set a target for wage increases of at least 5% (including a base increase of at least 3%) as in 2024 (Exhibit 2). Furthermore, for labor unions of small and medium-sized enterprises, the target is a wage increase of +6% or more. With labor supply and demand tightening due to labor shortages, we expect the 2025 Spring Labor Offensive to be generally in line with the target, as the earnings environment for small and medium-sized enterprises, in addition to large enterprises, is also generally firm.

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In the medium term, we expect the BOJ to gradually raise the policy rate to 1% at a cautious pace of 0.25% every six months, so as not to disturb the virtuous cycle between wages and prices. At the recent Monetary Policy Meetings, advisory board members of the Bank of Japan have expressed the opinion that the Bank will gradually raise the interest rate to the 1.0% level as early as in the second half of FY2025, if the economy and prices continue to move as expected. According to several models introduced by the BOJ, estimates of real neutral rate (the natural rate of interest), the real level of interest rates that neither overheats nor cools the economy, range from ▲1% to +0.5%, but in a world where 2% inflation takes hold, the neutral rate would be at least +1% (Exhibit 3). According to the Cabinet Office's macroeconomic model of the Japanese economy, a 1% hike in short-term interest rates would only result in a 0.3% decline in real GDP, so a rate hike of up to 1% would have limited adverse effects on the Japanese economy, which is a concern. Looking at the yen OIS market, the assumption is that the BOJ will raise interest rates only to about 0.8% by mid-2026 (Exhibit 4). Given the market's somewhat conservative assumptions regarding the final point of the BOJ's rate hike (terminal rate), we believe that Japanese long-term interest rates are likely to rise moderately in 2025 as the BOJ steadily raises rates. Therefore, although the foreign exchange market is likely to be led by the U.S. dollar, the yen is likely to come under slightly stronger pressure if we focus on domestic factors. In the stock market, the rise in long-term interest rates is likely to continue to provide support for some value stocks, including financial stocks.

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