Bank of Japan rate hike timing under scrutiny as price pressures shift

Few would want to be in the position of the BOJ at present. While inflation provides strong justification for further interest rate increases, the economy is already burdened by costly energy imports, a weak yen, and an extremely uncertain global environment.

To add to the difficulties, the current inflationary buildup is not of the sort the BOJ had wished for.

For decades, the BOJ has worked to cultivate a cycle of increasing wages, robust consumer spending, and steady price rises. Most of these initiatives proved fruitless. A worldwide economic upheaval from the Covid pandemic ultimately provided an escape.

Japan lived through prolonged stagnation in wages and prices over the past three decades. Companies were reluctant to increase prices, workers saw little wage growth, and consumers became used to low costs.

The pandemic followed, bringing supply chain breakdowns and soaring commodity prices. Companies were left with no option but to raise prices as inflation returned to Japan. This was initially cost-push inflation. Yet it also cracked Japan's longtime aversion to price increases, and employees started demanding higher pay to match rising living expenses.

For some time, Japan appeared to have the inflation pattern policymakers had long pursued. However, amid the US-Iran conflict this year, a large portion of the recent price spike originates elsewhere.

Rising oil prices and import expenses force businesses to pay more, costs that are eventually transferred to shoppers. This is once more a tale of cost-push inflation. In contrast to wage-driven inflation, it does not generally provide households with additional spending capacity; in fact, the opposite occurs.

The situation is underlined by Japan's newest trade data. The nation posted a ¥2.8 trillion trade shortfall for April–September, more than twice the roughly ¥1.2 trillion deficit from the comparable prior-year period. A 20.4% increase in imports, due to high energy costs, is the main driver.

This places the BOJ in a particularly awkward position. Having worked for years to ignite inflation, the bank must now consider whether the latest price pressures could undercut the wage-based recovery it has carefully promoted.

What does this situation imply for interest rates?

For the moment, markets essentially discount an October rate rise, but see roughly a 74% chance of a move in December. This matches recent BOJ communication, which points to a quarterly tightening pace to mitigate risks of inflation exceeding expectations.

Nevertheless, raising rates will not lower oil prices. A stronger yen may bring some respite, but this is far from certain when Treasury yields are high and the dollar remains in demand across global markets.

Meanwhile, higher borrowing costs might compress household spending and corporate investment when Japan can least afford a further drag on growth.

It is a no-win situation.

There is an element of irony. For decades the BOJ sought to break free from an economy with persistently stable prices. Now it risks tightening because prices are increasing for the wrong reasons.

It would be premature to call another rate hike a mistake. But the margin for error is growing smaller. After so many years of pursuing the right inflation policy, the BOJ can least afford a timing error.