Three Reasons Why I Expect the BOJ's Short-term Policy Rate to Rise No Further Than Zero

The Bank of Japan's October 2023 outlook report predicts that core Consumer Price Index (CPI) inflation, excluding fresh food and energy, will be 1.9% in both fiscal years 2024 and 2025. This projection suggests a potential move toward returning the short-term policy rate to zero. The rationale behind this lies in the possibility of justifying an end to negative rates once the forecast is upgraded to 2.0%, demonstrating increased confidence in meeting the inflation target. The FY26 forecast, set to be released in April 2024, may not be an absolute necessity for this decision. I anticipate the rate reaching zero as soon as reliable information about the direction of spring wage talks becomes available, likely by April.

Despite a prevalent market view that the Bank of Japan will continue to raise its policy rate into positive territory after achieving the 2% inflation target, I strongly disagree. The prevailing economic reality in Japan, with a potential growth rate of only about 0.5%, makes it highly unlikely to sustain a stable 2% inflation. In contrast, the United States, with the same inflation target, boasts a 1.8% potential growth rate.

While some argue for the feasibility of shifting inflation onto a higher trajectory, we view such attempts as grand social experiments heavily reliant on changing norms around prices and wages. The December Tankan report confirmed oversupply in sectors directly affecting consumer prices, presenting subtle but significant challenges for the Bank of Japan as it aims to end negative rates.

Although a return to a 0% short-term rate in the next few months seems likely, we identify three reasons casting doubt on the Bank's ability to subsequently lift it into positive territory.

1. Core CPI inflation is expected to dip below 2%, signalling a loss of price momentum. The "first force," as termed by Governor Kazuo Ueda, could lose energy, potentially depressing CPI inflation if the yen strengthens and commodity prices fall. Additionally, the "second force" of wage growth driving prices higher is unlikely to become a powerful, broad-based phenomenon, with my forecast indicating core CPI inflation of just 1.5% in FY25.
2. The yen is anticipated to appreciate in 2024 as the Federal Reserve and European Central Bank start to cut rates. The BOJ's pattern of maintaining accommodative policies while counterparts in the West tighten sharply is expected to reverse, leading to a stronger yen, lower prices, a slower economy, reduced corporate profits, and depressed share prices.
3. There is concern that higher rates could trigger a voter backlash if they significantly impact SME profits. Many small and medium-sized enterprises lack the financial means to absorb the combined impact of employee pay rises and higher borrowing costs. With a general election scheduled for October 2025, a substantial profit downturn among a voter group traditionally supporting the coalition could lead coalition MPs to resist additional BOJ rate hikes.

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