Can the Bank of Japan Continue to Swim Against the Tide?

The Bank of Japan recently hiked their policy rate, raising questions about the path of policy normalization in Japan. But domestic fundamentals and emerging global risks may make that path arduous.

The Bank of Japan (BOJ) recently hiked their policy rate by 25 bp to 0.50%, the highest level in 17 years. The economy had been prime for a hike, with a few interesting data developments – for instance, the sequential growth in Japan’s CPI was higher than that of the US in eight of the last nine months. We have had a long-standing call for the return of inflation in Japan, which led us to lift our forecast of 2025 CPI to 2.6% in December. Incidentally, the BOJ followed suit, and raised their 2025 forecast to 2.4% in January. The key question now is whether the BOJ will be able to continue normalizing their policy amidst an intensifying global easing wave. For the first time in two years, we think it is going to be difficult.

Domestic Fundamentals

The most crucial factor for the BOJ remains domestic fundamentals, which require continued higher wage growth. In fact, the BOJ’s January hike was based on the regional branch managers’ report, which noted that a wide range of firms already see the need to raise wages due to structural shortages. This is in line with our expectation that the labor market is near a Lewisian turning point, a situation where wage growth picks up after the labor market exhausts most available resources.

Japan’s labor force has been holding steady at nearly 70 million people, despite its working age population declining to about 74 million (Figure 1). This is essentially because the Japanese market managed to utilize most of its labor force including females and the elderly. As remarkable as it is, that utilization is near its limits now, and we think the labor market is ready to pass higher wage growth to attract and retain employment. Based on these structural developments, we expect the average salary increment to hold ground over 5%, in continuation from last year.

Interest Rates and the Yen

We are now gradually getting an idea about what the terminal rate in Japan could be. The BOJ in December released a report titled “Review of Monetary Policy from a Broad Perspective,” which featured six models estimating the real neutral rate. The results were between -1.0% and 0.50%, implying that even after the January hike, the current policy rate is well below the neutral rate. Still, we think the BOJ will continue to normalize policy at the rate of two hikes per annum and see a good chance for another hike this year, simply because of the inflationary pressures gripping the economy.

Majority of people surveyed by the BOJ each quarter have been reporting a spending increase, mainly because of higher prices and not necessarily because of higher demand. This highlights the sensitivity of economic growth to inflation and is perhaps one of the reasons why Japan’s real GDP on a level basis has not broken out of range in the last ten years.

Furthermore, the global macro landscape has gotten more volatile since Donald Trump came back to office. The potential mix of policies pursued by the new administration is deemed to benefit the US dollar, putting further downward pressure on the yen. This allows the BOJ to consider lowering the policy rate differential with the US, increasing the likelihood of another rate hike.

However, there are a few emerging risks, with the biggest being global in nature. When considering the BOJ’s policy rate in tandem with the wave of global easing, the risks become more apparent (Figure 2). It is important to pay attention to the data flow and the central bank’s communications. If economic activity eases unexpectedly, chances of further hikes reduce, but if activity holds up, there is a good chance for more.

Nonetheless, in our baseline scenario, we stick with our forecast for the policy rate to reach 0.75% by December 2025, and see the possibility of another hike as soon as July. It would depend on how the fiscal policy agenda sails through the ongoing ordinary Diet session, but we expect the Ishiba administration to fare better than general expectations. All of this is supportive of further policy normalization.

Investment implications

While we retain our favorable outlook for developed market sovereign bonds in 2025, the BOJ moving in the opposite direction should mean Japanese government bond (JGB) curve will stay steep in the near term as investors shun duration. However, we anticipate the JGB curve to potentially flatten in 2H25, with more room for the 5-year yield to rise than the longer end of the JGB curve (Figure 3).

As far as the yen is concerned, the currency is likely to stay within the 150-160 range versus the US dollar in the near term. But we see opportunities for the yen in cross-yen pairs (CHF/JPY, EUR/JPY, and GBP/JPY) as a reduction in carry for peers should reignite the yen’s status as a safe haven, trailing only the US dollar and gold.

Japan remained a large holder of foreign bonds up until 2022 when the Fed’s hiking cycle forced Japanese investors to reduce hedged foreign bond holdings. However, a gradual hiking cycle by the BOJ accompanied by a Fed cutting cycle should result in lower USD/JPY hedging cost (Figure 4).

This means foreign bonds should become attractive for Japanese investors again, with hedged US credit (JPY) now yielding at par with 10-year JGBs and having the potential to out yield JGBs into 2026. This would represent a tailwind for the US bond market especially within the higher quality credit cohorts.