A former Bank of Japan official has indicated that the central bank may need to accelerate its interest rate increases later this year, potentially pushing the benchmark rate above 2% as it works to contain inflation that is at risk of becoming unmanageable.
Tokyo University Professor Emeritus of Economics Tsutomu Watanabe, who left the Bank of Japan in 1999, stated in a media interview on Wednesday that the ultimate peak interest rate will likely exceed current market expectations. He suggested the terminal rate could be around 2% or possibly even slightly higher.
Under Governor Kazuo Ueda, the Bank of Japan has raised its benchmark rate five times, with the most recent hike last month bringing it to 1%, the highest level in 31 years. A survey of economists conducted after the June increase indicated that most anticipate another rate hike before year-end, with a projected terminal rate for this cycle of 1.75%.
So far, there are no clear signs that the rate hikes are significantly hampering business activity. Bank lending grew at its fastest pace since the pandemic in June, and the latest Tankan survey from the Bank of Japan showed that corporate financing conditions have improved for the first time in a year. Large companies reported better environments for issuing commercial paper.
Watanabe emphasized that policy should be considered dynamically, not statically. He explained that the terminal rate is not merely a mathematical calculation of the neutral rate but also incorporates factors like inflation overshooting before the central bank explicitly tightens policy.
He noted that authorities have so far adopted a reactive policy approach, aiming to achieve a virtuous cycle where wage increases drive demand-pull price rises. However, as underlying inflation nears the 2% target, the policy board may shift to a more proactive stance to prevent price growth from overshooting.
Watanabe, who was reportedly on the shortlist for the governorship alongside Ueda in 2023 and is a leading inflation expert in Japan, currently does not view overheating inflation as a severe threat. He believes the Bank of Japan still has time to assess wage momentum while awaiting information later this year to gauge wage growth prospects for 2027.
Nevertheless, if wage momentum proves as strong as in recent years, Watanabe's calculations based on a Taylor rule suggest underlying inflation could potentially exceed 2% next year. This could force the central bank to shift its stance toward combating inflation with policy settings deemed restrictive.
To date, the Bank of Japan has taken a gradual approach to raising rates while maintaining accommodative policy settings to generate a degree of inflation, as Japan continues to emerge from the deflation that severely impacted its economy for over a decade around the turn of the century.
A key challenge, Watanabe pointed out, is that unlike in Europe or the United States, inflation expectations in Japan are not anchored around 2%. This could make it more difficult for the central bank to convince businesses and households that price growth will remain near its target.
"If the Bank of Japan continues in passive mode against inflation for another year, it risks being backed into a corner where it must push through rate hikes quickly," Watanabe warned. "That would be very different from the gradual process Ueda has pursued so far."
Watanabe's hawkish comments follow data showing Japanese wages climbed again in May, easily outpacing inflation and reinforcing the case for the Bank of Japan to continue its hawkish policy path of further rate hikes.
A statistical report released Tuesday by Japan's Ministry of Health, Labour and Welfare showed nominal wages in May rose 3.2% year-over-year, following a revised 3.6% increase in April. The figure was slightly weaker than economists' average forecast but marked the fourth consecutive month of wage growth of at least 3%, the longest such streak since 1992.
This data comes after last week's release of the final statistics from this year's wage negotiations. Members of unions affiliated with Japan's largest labor federation secured wage increases exceeding 5% for the third consecutive year, the first such streak since 1989-1991.
The sustained strength in wages highlights employers' commitment to raising pay despite difficulties from Middle East geopolitical conflicts disrupting supply chains and significantly pushing up inflation. This reinforces the central bank's view that the virtuous wage-price cycle remains intact, keeping it on a hawkish policy track toward further rate hikes.
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