What is the next step for the Bank of Japan? HSBC provides a roadmap

On April 24th, Frederic Neumann, Chief Asia Economist of HSBC Global Research, released the latest research report titled "What's Next for the Bank of Japan?".

In the report, he pointed out that if inflation expectations continue to rise, theoretically, the Bank of Japan can raise nominal interest rates to tighten monetary policy while keeping real interest rates unchanged.

However, due to the significant downside risks to Japan's economic growth, the Bank of Japan's tightening policy needs to proceed gradually to help the economy adapt to a positive interest rate environment, and should not be rushed to avoid causing excessive impact on the economy and consumption. Of course, Japan's interest rate policy also depends on changes in interest rates in other regions (such as the United States). If the US interest rates remain relatively high for a long period, the Bank of Japan may raise rates more quickly.

Therefore, we predict that the Bank of Japan will raise the policy rate ceiling from 0.10% to 0.25% in the third quarter of 2024. Subsequently, it is expected that the rate will be raised by another 25 basis points to 0.50% in the first quarter of 2025, and further increased by 25 basis points to 0.75% in the third quarter of the same year.

In addition, considering Japan's strong wage growth and service sector inflation, we have revised our forecast for Japan's core CPI in 2025 from 1.9% to 2.2%.

How Fast Can the Bank of Japan Raise Interest Rates?

The Japanese economy seems to have escaped the long-standing deflation dilemma, with accelerated wage growth and rising inflation expectations indicating that Japan may have entered a virtuous cycle, allowing the Bank of Japan to eventually normalize its policy.

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

On the one hand, Neumann stated that if policy tightening occurs too quickly, it may lead to a strengthening of the yen, offsetting the inflationary effects previously brought about by yen depreciation:

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

The first is changes in the labor market, as labor shortages lead to wage increases.

The second is yen depreciation, which raises import costs, thereby increasing the inflation rate and also promoting demand for goods and growth in the tourism industry.

The second source already implies that the Bank of Japan must be cautious when considering policy adjustments. If policy tightening occurs too quickly, it may lead to a strengthening of the yen, offsetting the inflationary effects previously brought about by yen depreciation.

On the other hand, the Bank of Japan needs to be very cautious when considering raising interest rates, weighing the impact of this decision on different economic groups to avoid causing excessive impact on the economy and consumption:

First, tightening policy will affect borrowers and depositors. If interest rates rise, borrowers (such as mortgage holders) will need to pay more in loan interest, meaning their debt payments will increase, while depositors with savings will receive higher 'income' from interest.

Therefore, consumer spending will be influenced by three factors: (1) wage growth; (2) the proportion of households with and without debt; (3) the consumption tendencies of debtors and depositors All these uncertainties require caution from the Bank of Japan. The Bank of Japan needs to gradually advance its policies to avoid the 'impact' of rising nominal interest rates on consumption.

Secondly, public debt is also a factor to consider. For example, a rapid increase in interest rates may lead to an increase in government bond yields, which will increase the government's interest expenses. As more debt matures and needs to be refinanced, this impact will gradually become apparent. This may require the government to readjust the priorities of public spending, reducing expenditures on investments and other government services, which may have adverse effects on 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 may also jeopardize public finances, which could limit the Bank of Japan's willingness to tighten policy quickly.

Of course, there are also some mitigating factors, such as rapid nominal GDP growth slowing the increase in the debt-to-GDP ratio, and Japan's good tax elasticity (the ability of tax revenue to increase with economic growth), which helps accelerate the pace of taxation.

Additionally, Japan's interest rate policy partly depends on interest rate changes in other regions (such as the United States). If the US interest rates remain relatively high for a long time, the Bank of Japan may raise rates more quickly.

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

Neumann points out that given the significant downside risks to economic growth, 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 is expected to raise its policy rate target from 0.10% to 0.25% in the third quarter of 2024, then increase it by another 25 basis points to 0.50% in the first quarter of 2025, and then raise it by another 25 basis points to 0.75% in the third quarter of the same year (still well below the neutral nominal interest rate). This path takes into account the cycle of wage growth for small and medium-sized enterprises and its timing in macroeconomic data.

Neumann points out that on the one hand, if inflation expectations continue to rise, theoretically, the Bank of Japan can raise nominal interest rates (the announced rates) without changing the real interest rate (the rate adjusted for inflation). Currently, inflation expectations seem likely to stabilize around 2%, which means the Bank of Japan could raise rates by about 150 basis points (bringing the real interest rate close to its long-term average level, around -0.5%), without causing significant harm to the economy.

While theoretically feasible, raising rates in practice would be more complex. For economies that have maintained extremely low interest rates for a long time, once the Bank of Japan raises nominal rates, it may have some destructive effects on the economy. This is because changes in interest rates affect borrowing costs, people's consumption, and corporate investment, among other things.

Chart 1: HSBC's new policy rate and inflation forecast Of course, if the economic growth situation improves, for example, if Japan invests in labor-saving technology or corporate reforms to increase productivity, then the neutral real interest rate may rise over time (i.e. the level of interest rate that neither promotes nor inhibits economic growth). However, there is not yet much concrete evidence to support this.

Japan's economy enters a new inflation phase, government debt burden may be manageable

Neumann believes that the risk is that continued loose monetary policy may further push up inflation, leading to consumer price increases exceeding the Bank of Japan's target, while asset prices continue to rise. On the other hand, to ensure the stability of the reflation process, especially after experiencing prolonged deflationary pressures, the Bank of Japan needs 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. However, complicating the issue is that the Bank of Japan's monetary policy stance is influenced not only by policy interest rates but also by the size and composition of its balance sheet. Under otherwise identical conditions, 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 guidance is to maintain stability in its balance sheet, with interest rate adjustments as the primary monetary policy tool. However, over time, this situation may change, for example, by adjusting the speed of government bond purchases to control bond yield fluctuations while smoothing government financing operations.

Furthermore, the reflation phenomenon in the Japanese economy suggests that, for Japan, while raising interest rates may increase the government's future debt servicing costs (because borrowing becomes more expensive), overall economic growth (i.e. nominal GDP growth) helps partially offset this impact, controlling the ratio of national debt to Gross Domestic Product (GDP).

At the same time, Japan's long-term tax revenue elasticity coefficient is estimated to be above 1 (tax revenue elasticity refers to the ability of tax revenue to increase with economic growth. In Japan, a tax revenue elasticity above 1 means that when the economy grows, the proportion of tax revenue increase exceeds the proportion of economic growth), so economic growth can bring in more tax revenue, helping the government cope with the increased debt interest burden due to rising interest rates.

In conclusion, the Japanese economy seems to be entering a new inflationary cycle. The Bank of Japan needs to gradually reduce the nominal level of monetary easing, but in reality (considering inflation), it still needs to maintain a certain degree of easing. In the medium term, an improvement in economic productivity is necessary to help the Bank of Japan achieve a neutral monetary policy goal (i.e. a policy state that neither stimulates nor inhibits economic growth), but currently, productivity growth remains elusive and insufficiently convincing