In response to the potential for higher energy prices and increased inflation risks stemming from conflict in Iran, Bank of Japan Governor Kazuo Ueda has fully pivoted his policy focus towards combating inflation. A rate hike in June is now highly probable, with the frequency of subsequent interest rate increases also likely to rise significantly.
Governor Ueda's public remarks on Wednesday marked a departure from his previous dovish tone, emphasizing that the central bank is prepared to adjust policy and that allowing inflation to persist would harm Japan's real economy. This statement reshapes the logic of Japanese monetary policy, indicating that interest rate decisions will no longer be anchored solely to steadily achieving the 2% inflation target but will instead place inflation upside risks at the core of decision-making.
The key shift is that the Bank of Japan is no longer tolerant of inflation driven by supply shocks. Ueda explicitly stated that if price pressures stemming from geopolitical conflicts spread across the entire industrial chain, triggering a second-round inflation pass-through, the central bank would not remain idle in the face of rising prices.
This also marks a new phase in his five-year term as governor. Initially focused on gradually dismantling the unconventional easing policies left by his predecessor, Ueda is now formally steering the Bank of Japan back to its conventional central banking functions: anchoring inflation levels and managing price increases.
The Bank of Japan ended its decade-long massive stimulus program in 2024, including a rate hike in December of last year, at a time when markets judged that Japan was on a firm path to achieving its 2% inflation target.
Ueda stated, "Even with the uncertain outlook for the Middle East situation, if we judge that the risks of prices rising outweigh the risks of the economy deteriorating, we will consider the pros and cons of raising the policy interest rate." This wording is similar to his remarks prior to the December rate hike, further solidifying market expectations for a hike at the policy meeting on June 15-16.
Compared to the past, Ueda has now broadened the conditions that could trigger a rate hike. Previously, the Bank of Japan's policy tightening was consistently framed around steadily achieving the 2% inflation target and exiting easing gradually. Now, a new rule has been added: a single, significant inflation risk could trigger a hike. Ueda warned that Japanese corporate pricing logic has already shifted, and energy shocks could easily amplify broad-based inflationary pressures.
Two individuals familiar with the central bank's internal assessment revealed that, barring an extreme escalation of the Middle East conflict, a June rate hike is almost certain. Ueda also cautioned that the drawbacks of delaying a hike are becoming apparent, as rising raw material costs have already pushed up Japanese wholesale prices, a trend that will continue to spread to end-consumer prices.
Senior central bank watcher Mari Iwashita noted that the shift in the central bank's communication directly reflects its anxiety over prices, making a June hike a foregone conclusion. She predicts that the wave of price increases driven by geopolitics is just beginning, with inflationary pressures likely to rise further during the summer. Ueda's remarks suggest the Bank of Japan may also be forced to raise rates in the autumn, potentially accelerating the pace of the tightening cycle.
Balancing Government Concerns: A Single Hike Unlikely to Reverse Yen's Weakness
While signaling a hawkish shift towards rate hikes, Ueda also sought to reassure the Japanese government, which favors loose policy, and to ease market concerns that rate hikes could burden the economy. He framed potential rate increases as a defensive measure to protect household purchasing power. Considering the government's apprehension about rising borrowing costs, he stated that timely rate hikes could stabilize market confidence and avoid financial turmoil caused by disorderly surges in government bond yields.
However, despite the central bank's shift towards tightening, the yen continues to depreciate, reflecting market skepticism about the effectiveness of rate hikes. The USD/JPY pair is hovering near the 160 level, seen as a key line for potential intervention by Japanese authorities. The persistent weakness of the yen continues to increase import costs and domestic prices, further exacerbating inflationary pressures.
Rinto Maruyama, a strategist at Mitsui Bussan Global Securities, pointed out that a single rate hike in June is unlikely to reverse the yen's downtrend. To bring about a substantial rebound in the exchange rate, the Bank of Japan would need to send a strong signal of sustained and intensified monetary tightening.
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