On April 24, Frederic Neumann, the chief Asian economist of HSBC Global Research, released the latest research report entitled “What's Next for the Bank of Japan?”

In his research report, he pointed out that if inflation expectations continue to rise, the Bank of Japan can theoretically raise nominal interest rates to raise interest rates while real interest rates remain unchanged.

However, since the downside risk of Japan's economic growth is still quite high, the Bank of Japan's tightening policy needs to be gradual to help the economy adapt to a positive interest rate environment, and it must not be too hasty to avoid causing too much impact on 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 US. If interest rates in the US remain high for a long time, the Bank of Japan may raise interest rates faster.

Therefore, we predict that the Bank of Japan will raise the upper limit of the policy interest rate from 0.10% to 0.25% in the third quarter of 2024. After that, interest rates are expected to be raised again by 25 basis points to 0.50% in the first quarter of 2025, and a further increase of 25 basis points to 0.75% in the third quarter of the same year.

Furthermore, taking into account Japan's strong wage growth and service sector inflation, our forecast for Japan's 2025 core CPI was raised from 1.9% to 2.2%.

How fast can the Bank of Japan raise interest rates?

The Japanese economy seems to have escaped a long period of deflation, and the acceleration of wage growth and rising expectations of inflation suggest that Japan may have begun to enter a virtuous cycle, which will allow the Bank of Japan to finally normalize its policies.

One key question is: How fast can the Bank of Japan raise interest rates without disrupting the re-inflation process?

On the one hand, Neumann said that if the policy is tightened too quickly, it may cause the yen to appreciate, thereby offsetting the effects of inflation driven by the depreciation of the yen before:

There are two main sources of re-inflation in Japan:

The first is changes in the labor market. Wages have begun to rise due to labor shortages.

The second is the depreciation of the yen, which has led to an increase in import costs, which has boosted the rate of inflation, while also boosting demand for commodities and the growth of tourism.

The second source already suggests that the Bank of Japan must be careful when considering policy adjustments. If policies are tightened too quickly, the yen may appreciate, thereby offsetting the inflation-boosting effects previously brought about by the depreciation of the yen.

On the other hand, the Bank of Japan needs to be very careful when considering raising interest rates. It must weigh the extent to which this decision affects different economic groups to avoid excessive impact on the economy and consumption:

First, tighter policies will affect borrowers and savers. If interest rates rise, borrowers (such as mortgages) will have to pay more interest on their loans, which means that their debt expenses will increase, and depositor savers will receive higher 'income' due to increased interest income.

As a result, consumer spending will be affected by three factors: (1) wage growth; (2) ratio of indebted households to unindebted households; and (3) consumption tendencies of debtors and savers.

The uncertainty of all these factors requires the Bank of Japan to act with caution. The Bank of Japan needs to gradually advance its policies so that the distributive consequences of rising nominal interest rates do not have an “impact” on consumption.

Second, public debt is also a factor to consider. For example, a rapid rise in interest rates may lead to higher yields on government bonds, which will increase the government's interest expenses. This impact will gradually become apparent as more debt matures and needs to be refunded. This may require the government to reprioritize public spending and reduce spending on investment and other government services, which could adversely affect GDP growth, particularly 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 may also jeopardize public finances, which may limit the Bank of Japan's will to quickly tighten policy.

Of course, there are also mitigating factors. For example, rapid growth in nominal GDP will slow the rise in debt as a share of GDP, and Japan's good tax flexibility (ability to increase tax revenue with economic growth) will help speed up the pace of taxation.

Furthermore, Japan's interest rate policy depends in part on changes in interest rates in other regions, such as the US. If interest rates in the US remain high for a long time, the Bank of Japan may raise interest rates faster.

What is the extent of the Bank of Japan's interest rate hike in the future?

Neumann pointed out that since the downside risks to economic growth are still quite large, the Bank of Japan will need to gradually raise interest rates to minimize disruptions and help the economy adapt to a positive interest rate environment.

According to forecasts, the Bank of Japan will raise its policy interest rate ceiling target from 0.10% to 0.25% in the third quarter of 2024, then raise it by 25 basis points to 0.50% in the first quarter of 2025, then raise it again by 25 basis points to 0.75% in the third quarter of the same year (of course, this is still far below the neutral nominal interest rate). This path takes into account the wage growth cycle of small and medium-sized enterprises and the timing of its reflection in macroeconomic data.

Neumann pointed out, on the one hand, if inflation expectations continue to rise, the Bank of Japan can theoretically raise the nominal interest rate (that is, the announced interest rate) while the actual interest rate (considering the interest rate after inflation) remains unchanged. Currently, inflation expectations seem likely to stabilize at around 2%, which means that the Bank of Japan can raise interest rates by about 150 basis points (thus bringing real interest rates close to its long-term average of about -0.5%) without causing much damage to the economy.

While it is theoretically possible to raise interest rates, the actual operation would be more complicated. For economies that maintain extremely low interest rates for a long time, once the Bank of Japan raises nominal interest rates, this may have some damaging effects on the economy. This is because changes in interest rates affect borrowing costs, people's consumption, and company investment.

Of course, if economic growth improves, such as Japan increases productivity by investing in labor-saving technology or corporate reforms, then neutral real interest rates may increase over time (that is, the level of interest rates that do not promote or inhibit economic growth). However, there isn't much hard evidence of this yet.

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

Neumann believes that the risk is that continued monetary policy easing may further push up inflation, causing consumer prices to rise above the Bank of Japan's target, while asset prices continue to rise. On the other hand, in order to ensure the stabilization of the re-inflation process, especially after a long period of continuous deflationary pressure, it is necessary for the Bank of Japan to consolidate the upward trend in inflation expectations. In short, the Bank of Japan is currently facing an unprecedented delicate balance.

So far, this policy framework has been relatively straightforward. Complicating matters, however, is that the Bank of Japan's monetary policy position is affected not only by the policy interest rate, but also by the size and composition of the balance sheet. Other things being equal, a rapid contraction or expansion of the balance sheet may eliminate the need for faster or slower interest rate adjustments.

Currently, the Bank of Japan's guideline is to maintain a stable balance sheet and allow interest rate adjustments as the main monetary policy tool. However, this situation may change over time, for example by adjusting the speed at which treasury bonds are purchased to control fluctuations in bond yields while smoothing government financing operations.

Furthermore, the re-inflation of the Japanese economy shows that for Japan, although raising interest rates may increase the government's future debt repayment costs (because interest on borrowed money is higher), overall economic growth (that is, nominal GDP growth) can help partially offset this impact and control the ratio of national debt to gross domestic product (GDP).

Meanwhile, Japan's long-term tax elasticity coefficient is estimated to exceed 1 (tax elasticity refers to the ability of tax revenue to increase with economic growth. (In Japan, tax elasticity above 1 means that when the economy grows, the rate of tax increase exceeds the rate of economic growth.) Thus, economic growth can bring in more taxes and help the government cope with increased debt interest burdens due to rising interest rates.

All in all, the Japanese economy appears to be in a new cycle of inflation. The Bank of Japan needs to gradually reduce the nominal level of monetary easing, but in reality (after considering inflation), it still needs to maintain a certain level of easing. In the medium term, an increase in economic productivity is necessary to help the Bank of Japan achieve neutral monetary policy goals (that is, a policy state that neither stimulates nor inhibits economic growth), yet productivity growth is still elusive and not convincing enough.

Editor/Somer