Bank of Japan to keep the hiking cycle in place this year

Market & Trading Calls

• Growth Rebound: The Japanese economy flatlined in 2024 finishing up just 0.1% y/y. We currently assume an improvement in fortunes with growth expected to finish at 1.3% this year, albeit this will need to be revised lower if mixed signals around household expenditure translate to weaker than expected household demand growth.
• BoJ Policy: Core inflation, currently holding at 3.2% when measured over a six month period, remains well above the BoJ target. It is for this reason that we expect Ueda and the rest of the BoJ policy committee to raise rates by another 50bp this year, bringing the policy rate to 1%. This expectation currently outpaces the bond market, which sees rates higher just 12bp by this time next year.
• Mixed Consumption Signals: While consumer spending flatlined in Q4, a tight labor market, and positive real retail trade in January, point to improvements to start 2025. However, a contractionary preliminary services PMI read for March, and a sizeable decline in real wages through January are concerning developments that will need to be monitored.
• Weak Investment Outlook: Rising long-duration rates and uncertainties around US tariff policy are poised to keep investment on the sidelines through much of this year. Manufacturing PMIs continue to look excessively weak, and industrial production levels declined 12.3% m/m annualized in January.

Market Analysis

Inflation remains persistently above target, but the BoJ pauses the hiking cycle for now in anticipation of US reciprocal tariffs.

According to the Q4 GDP report, the Japanese economy continues to show signs of life. Headline inflation-adjusted output finished the final three months of the year up 2.24% q/q annualized, marking the third straight quarterly gain, and a pickup in growth against a 1.4% q/q annualized increase seen in Q4. The momentum is a welcome change after Japan’s economy contracted for three straight quarters between H2 2023 and Q1 2024. Aggregate output is now back above the previous post-Covid peak achieved in Q2 2023. We currently forecast Japanese headline GDP to increase 1.3% y/y in 2025, up from just 0.1% over full year 2024.

Quarterly Japanese Headline GDP (JPY bn, left) and Q/Q % Annualized Delta (right)

Source: eStat

Healthy Q4 growth figures kept the pressure on inflation, which continues to run above the BoJ’s 2% target. Core inflation for February, which removes volatile food and energy, was holding at 3.2% annualized when measured over a six month period. The one month rate of inflation has been choppy, rising to 4.5% annualized in January before easing back to 2.2% in February. Nominal wage growth, which accelerated to 7.8% y/y in December, is no doubt a driver of Japan’s persistent inflation issues.

Monthly One- and Six-Month Rate of Headline Inflation (%)

Source: eStat

The steady uptick in Japanese economic output and inflation in recent months has come despite a slow tightening in monetary policy. In January, the BoJ hiked the official policy rate by 25bp to 0.5% in an effort to stave off inflation that remains above target while simultaneously providing support to the Japanese Yen (JPY). Nonetheless, given rising uncertainty around Trump trade policy, it appears that the BoJ is pausing the hiking cycle for now, but further tightening is certainly possible later this year. Governor Ueda, who oversees BoJ policy, said “…it’s difficult to judge how much closer we are to achieving our goal when uncertainties over the US and overseas trade policies are high.” Clearly Ueda seems to be leaving the door open for further BoJ action.

The outlook for US – Japanese trade relations remain highly uncertain. According to Professor Kawasaki of the National Graduate Institute for Policy studies, Japanese import tariffs on US goods outpace those of US tariffs on Japanese goods by roughly 1.8 percentage points. It is unclear whether Japan would lower tariffs, or the United States would raise tariffs. The White House has also floated additional automotive based tariffs, and while an imperfect measure due to other-country pass throughs, and the use of tax havens, Japan ran a $64bn trade surplus with the United States in 2024.

Daily Japanese Selected Interest Rates (%)

Source: BoJ

The bond market appears split on the likelihood of further BoJ rate hikes. The 1y Japanese bond yield is currently trading at 0.62%, implying another 12bp of interest rate increases. We sit on the hawkish side of the BoJ rate decision and would argue we see another 50bp of rate hikes this year, especially if Japanese growth shows improvement, as we expect, and inflation remains above target. The 10y yield, which reveals views on inflation and growth, has surged to 1.52% year-to-date, up from 1.1% entering 2025.

JPY valuation remains front of mind for monetary policymakers. A weaker US dollar (USD) over the past two months has eased the pressure to appear hawkish. Despite a rebound back to 150 on USD/JPY since mid-March, JPY is still up 5% against the post Donald Trump election peak from early-January. We remain bullish on the prospects for JPY in the coming months. A combination of slow, yet steady rate hikes, and a rather healthy economic environment should provide support.

Monthly Average USD/JPY Rate of Exchange (top) and M/M % Delta (bottom)

Source: FMP

Hopes of an improvement in consumption come under pressure amid a return to negative real wage growth; fixed investment to remain weak this year.

The outlook for the Japanese economy, which we expect to expand at 1.3% this year, is split between that of a mixed to positive outlook for household consumption (52% of GDP), and a weaker outlook for fixed investment (25% of GDP). While household demand stagnated in Q4, finishing flat q/q, the environment looks supportive of more consumption growth this year. The Japanese labor market remains tight. The unemployment rate is holding at 2.5%, just above the multi-decade low 2.3% seen in 2019. Inflation-adjusted retail trade in January also finished higher against month earlier levels, a positive measure that will feed into the Q1 GDP report.

Monthly Japanese Real Wage Growth (Y/Y % Delta)

Source: Statistics Japan

However, we admit that other real time measures of household expenditure are less reassuring. Real wage growth flipped deeply negative again in January, finishing down 1.7% y/y, the largest decline in nine months. Preliminary service PMI figures for March also indicate a return to contraction following a strong start to the year. If the pace of household consumption growth does not manage to show improvement off a weak Q4 baseline, we will need to revise lower our forecast for real Japanese GDP. We would assume that if weakness shows itself across consumption, it will come in Q2 of this year at the earliest.

While the consumption side of the Japanese economy is sending mixed signals, the picture looks weak across the board when it comes to investment. A weakening investment outlook is driven by two key factors. First, long duration rates, which feed into investment decisions, continue to rise. At present, the 10y Japanese bond yield is trading at 1.52%, easily marking the highest level in nearly 15 years. Further increases look likely as the BoJ continues to hike rates, and concerns about inflation persist. Second, uncertainties around tariff policy will also keep capital on the sidelines, at least through the first half of this year.

A variety of monthly measures of fixed investment are hardly reassuring. Manufacturing PMI figures continue to draw ever deeper into contraction with preliminary reports for March at the lowest sub-50 level since early-2024. Industrial production finished January down 12.3% m/m annualized, the third monthly decline in a row amid flatlining investment through the final three quarters of 2024. Housing starts look just as weak, breaking to the lowest level in more than a decade in January.

Monthly Industrial Production Index (top) and M/M % Delta Annualized (bottom)

Source: METI

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