Barclays: Just "talking the talk" is not enough, the Bank of Japan may raise interest rates in July

The Japanese yen continues to weaken, economic recovery remains stable, and the prospect of wage increases is optimistic... Could the Bank of Japan raise interest rates faster than expected?

Barclays Bank released a research report on March 29, stating that influencing market pricing of policy rates through "verbal" means alone is "quite challenging" for the Bank of Japan. Therefore, Barclays continues to expect the Bank of Japan to raise interest rates to 0.25% in July, possibly raise them again in April 2025, and revise its expectations for the terminal interest rate to 0.5%.

In a market where a further rate hike is not expected in the near future, Barclays' forecast appears to be quite aggressive.

Barclays stated that given the continued weakness of the Japanese yen, rising oil prices, and wage growth at a critical point of "supporting/not supporting rate hikes," the risks of the Bank of Japan's interest rate hike path are biased towards the upside. If the aforementioned conditions are stronger than expected, the Bank of Japan may also advance the timing of a third rate hike.

Continued Weakness of the Japanese Yen Requires Government Intervention Urgently

Barclays stated that the excessively weak yen will continue to be a focus of attention for the Bank of Japan. Since the Bank of Japan announced a rate hike in March, the yen has continuously depreciated to a 34-year low.

Wall Street News previously mentioned that the USD/JPY has soared above 151, approaching the exchange rate level (151.97) of the last direct intervention in the foreign exchange market by Japan, and Japan's top foreign exchange official has verbally intervened twice in a week, increasing the risk of Japan taking action in the foreign exchange market.

On March 22, Japanese Finance Minister Taro Aso also made verbal interventions, warning that the authorities are "closely watching interest rates with a high sense of urgency."

Bank of Japan Governor Haruhiko Kuroda previously stated:

"If the exchange rate has a significant impact on the Bank of Japan's economic activity and price outlook, the Bank of Japan will naturally consider taking monetary policy measures. In light of this, we will consider the relationship between the outlook for US and Japanese policy rates and the USD/JPY exchange rate, as well as the relationship between the USD/JPY exchange rate and inflation."

Barclays believes that if there is no significant downward adjustment in interest rates on the U.S. side, the Bank of Japan will need to raise rates in the near future to correct the continued weakness of the yen.

We have constructed a theoretical model of the sensitivity of the USD/JPY exchange rate to the implied interest rate differential, showing that for every 0.1 percentage point change in the implied interest rate differential, the USD/JPY level fluctuates by 1.4 yen. Based on the model's estimation, it can be observed that:

• Assuming the pricing of U.S. policy rates remains unchanged, if the market pricing of Japanese policy rates rises by 0.5 percentage points from the current level of about 0.5%, the USD/JPY could drop by approximately 5% from the current spot rate (as of March 25 at 151.3) Barclays stated that due to the recent depreciation of the Japanese yen and the rise in oil prices, the possibility of upward pressure on commodity inflation is increasing.

The report shows that the impact of the USD/JPY exchange rate on core CPI has become more significant after the COVID-19 pandemic, indicating that Japanese companies are more actively passing on the cost of yen depreciation to product prices after the pandemic.

Before the COVID-19 pandemic, a 10% depreciation of the yen had a peak impact of about 0.3% on core CPI inflation after 5 months, with the statistically significant impact disappearing after 6 months. However, after the COVID-19 pandemic, this impact peaked after eight months at around 0.5%, and the statistically significant impact lasted for over a year.

Furthermore, the recent increase in oil prices is also becoming a greater driving force for higher inflation.

According to the model mentioned above, estimating the impact path of a 10% increase in Dubai crude oil prices (in USD) on core CPI inflation. The results show that since the COVID-19 pandemic, the cumulative impact has increased. Specifically, although the peak impact has decreased from 0.2% before the pandemic to 0.13% after the pandemic, the statistical significance period has significantly extended from 12 months to around 18 months, leading to the latter's cumulative impact being about 1.2 times the original, further amplifying the risk of yen depreciation.

In addition, in terms of the wage/inflation cycle that the Bank of Japan has long been concerned about, Barclays expects the final wage growth rate this year to reach 4.6%, with the possibility of further increases. When the overall nominal wage growth exceeds the critical point of 1.11%, service inflation will experience nonlinear growth (the magnitude of the increase will be greater).

It is expected that wages will be raised as planned from around April to July. As cost-push inflation also slows down, we believe that the likelihood of real wage growth turning positive is increasing Nominal wages have shown a steady growth of 2% in the past six months ending in January 2024, coupled with a significant increase in wages this year, the likelihood of a slight rebound in real wages around June is increasing, and the already stable service inflation around 3% may further rise.

Finally, the report also mentioned another key indicator for assessing economic activity and inflation: the output gap.

Currently, the Bank of Japan estimates that the output gap is still slightly negative, meaning that limited production capacity is due to weak demand. Barclays predicts that if real wage growth turns positive starting from mid-year, consumer spending is expected to recover, and the output gap is expected to turn positive around mid-year as well.

Although the effectiveness of using this indicator as a leading indicator of wage and inflation pressures is still questioned, the report suggests that attention should be paid to the central bank's communication in this regard, which may increase the possibility of inflation rising.

Limited room for further rate hikes after July rate hike

The report also states that once the interest rate is raised to 0.25%, the obstacles to further rate hikes may significantly increase, as this would have a noticeable impact on the economy for the first time, taking into account the potential political implications.

Therefore, Barclays expects the Bank of Japan to maintain a cautious stance for a longer period after the rate hike in July, although the Lower House election in 2024 and the U.S. election in November pose risks.

Overall, based on considerations of economic activity, prices, and financial conditions, Barclays predicts a bias towards hiking rates earlier.

If the yen continues to be excessively weak and inflation remains stronger than expected due to the aforementioned factors, Barclays believes that after the rate hike at the July meeting, the Bank of Japan may consider another rate hike at the October or January next year monetary policy meetings.

We believe that based on the outlook for inflation and profit growth this year, the wage increase for the fiscal year 2025 may be lower than that of fiscal year 2024 (from April 1 of this year to March 1 of next year).

Nevertheless, Japan seems to have reached the second Lewis turning point (a turning point from labor surplus to shortage), with the issue of labor shortage becoming increasingly prominent, leading to a significant change in the wage-raising mentality of Japanese companies. Therefore, even if the wage increase for fiscal year 2025 is lower than that of fiscal year 2024, we still believe that it may be higher than that of fiscal year 2023 and remain at a high level for the third consecutive year