Japan has rejoined central bank orthodoxy.  The move away from negative policy interest rates indicates the Bank of Japan (BOJ) believes inflation can be sustained at or close to its 2% target. We broadly agree with that assessment. Consequently, we believe the BOJ will likely slowly increase the policy rate to around 1% by end-2027.

Possible international spillover warrants caution.  Changes in market assumptions about monetary policy in Japan or the U.S. could lead to a significant realignment of international capital flows, given Japan's sizable international financial investment. The BOJ will continue to be careful in its actions and comments, in our view, to limit sudden changes in expectations and rumblings in financial markets. Indeed, following its recent interest rate move, the BOJ stressed that it "anticipates that accommodative financial conditions will be maintained for the time being".

The BOJ in March became the last major central bank to move away from negative rates.  After about eight years of negative rates, the central bank raised its policy rate to 0%-0.1%, from -0.1% (see chart 1).

In the aftermath of the global financial crisis, many developed-market central banks lowered their policy rates to low levels. When economic growth remained weak and inflation low, some countries moved policy rates into negative territory, in addition to implementing quantitative easing (QE). The aim was to encourage banks to lend more, thus stimulating economic growth.

The BOJ introduced QE in 2013, after grappling with very low inflation and subdued growth for a long time. In 2016 it moved to negative policy interest rates and yield curve control--a bold initiative to control the long-term government bond yield.

Other major central banks started to raise their policy rates significantly in 2022. Inflation was rising amid global supply-chain snarls and the Russia/Ukraine conflict. Strong demand conditions also supported price increases.

Inflation rose more slowly in Japan, amid conservative price and wage-setting habits, in part shaped by decades of low inflation. But conditions have recently starting to lead to more entrenched inflation.

Recent economic activity data has been weak. Yet, the estimated 5.3% wage growth agreed on in the spring round of wage negotiations between unions and the first batch of large employers was high enough for the BOJ to be comfortable with changing its policy, we assume. For reference, the unions in 2023 achieved a 3.6% wage increase in that first round.

Solid wage growth has been an essential condition for the BOJ's move to positive policy rates.  The growth makes it likely that significant inflation can be sustained in coming years, rather than petering out following the recent spurt. The wage agreements only cover a small share of the labor force. But they will provide a signaling function.

While the BOJ also relaxed its yield-curve control, it retained a commitment to dampen rate increases in the bond market.  It removed the 1% upper band for 10-year government bond yields. However, it committed to make "nimble responses, such as increasing the amount of Japanese government bond [JGB] purchases" in case of "a rapid rise in long-term interest rates". In addition, it will continue to regularly buy JGBs to offset the expiration of bonds in its large portfolio. The 10-year JGB yield was around 0.8% in early April (see chart 2).

Chart 1

Chart 2

Japan's price and wage-setting behavior is gradually changing.  Following decades of little to no inflation, there are signs that the recent inflation episode has led more firms to raise prices. The spike was kickstarted by higher commodity and energy prices and currency depreciation. Consumer prices of services are now rising at a bit more than 2% on a year ago for the first time in decades (see chart 3). Importantly, firms' inflation expectations have risen.

According to the March Tankan survey, corporates' views on consumer inflation remained in line with the BOJ's official 2% target.

• The one-year inflation expectation captured in the survey was 2.4%;
• The three-year outlook was 2.2%;
• The five-year inflation projection described in the survey was 2.1%.

Meanwhile, with firms' pricing power improving, they are becoming more willing to accommodate demands for wage increases.  Amid a shrinking workforce, tight labor markets, and rising inflation expectations, workers have become more assertive with their demands for higher wages. This is especially true for younger people--the spring wage negotiations were testament to that. The shift in price and wage-setting behavior will continue but it is unlikely to peter out.

• We project medium-term inflation of 1.5%-2%.
• From likely 2.3% headline consumer inflation in 2024, we assume a 2% level in 2025 and 1.7% in 2026.
• Risks are somewhat tilted to the upside, due to additional upward pressure from changes in price and wage-setting behavior.

Such inflation close to the BOJ's formal target of 2% should support positive policy interest rates.  Positive rates would lift nominal revenue growth for firms and the government, offsetting the impact of higher interest costs. There will likely be further modest increases in interest rates in coming years (see chart 4).

Chart 3

Chart 4

Having said that, we expect Japan's interest rates to remain meaningfully lower than in other major advanced economies.  Japan's real "neutral" interest rate is unlikely to have changed much from the estimates done before the pandemic. The neutral rate is the rate that keeps the economy in equilibrium, without excess supply or demand.

Trends in saving, investment and demographics drive neutral rates, and these trends haven't changed substantially in recent years. Indeed, in 2023 the International Monetary Fund estimated the real neutral rate at around -0.5%. Combined with around 1.5%-2% inflation, that would suggest a nominal neutral rate of 1%-1.5%.

The impact of BOJ policy on the yen is likely to be modest compared to that of U.S. monetary policy.  Despite the rise in the BOJ's policy rate, the yen weakened against the U.S. dollar in recent weeks. That is because of the more significant shift in expectations about the U.S. Federal Reserve's policy rates.

In coming months, such changing perceptions about U.S. monetary policy are likely to dominate in terms of the impact on the yen. They may test the government's tolerance for depreciation. Having said that, given that current exchange rate moves are about across-the-board U.S. dollar strength, the bar for foreign exchange market intervention will likely be high.

Related Research

• Global Economic Outlook Q2 2024: Still Resilient, With Gradual Rate Cuts Ahead, March 28, 2024
• Economic Outlook Asia-Pacific Q2 2024: APAC Bides Its Time On Monetary Policy Easing, March 26, 2024
• The U.S. Economy Bucks The Global Trend, Feb. 29. 2024
• Japan Structured Finance Outlook: Inflation Entrenches?, Jan. 11, 2024