BOJ may signal inflation hit 2% target, keeping December rate hike firmly in play

What happened

Sources familiar with the Bank of Japan's (BOJ) thinking suggest the central bank may signal in its October quarterly outlook that underlying inflation has roughly reached its 2% target. This communication would mark a significant symbolic shift, after years of striving to generate sustainable inflation.

While another rate hike is not expected for the October meeting, this signal underscores the BOJ's readiness for further policy tightening in the coming months. The report points to steady wage gains alongside firmer consumer and wholesale inflation as reasons for this potential shift in tone. Recent Tokyo inflation data and the BOJ's Tankan survey have also bolstered confidence that underlying inflation is now close to the 2% target.

However, the BOJ appears to lack urgency to move again immediately after having already raised rates in September. Many within the central bank reportedly prefer a more cautious step in October, wanting to gauge more data on how previous rate hikes are filtering through to the economy. The market appears to be thinking along similar lines, with traders pricing in around an 86% chance that the BOJ will leave rates unchanged in October.

The bigger question now concerns what happens next. Markets are currently assigning roughly a 64% chance of another rate hike by December. Any formal acknowledgement that underlying inflation has effectively reached the 2% target would support this view and align with the gradual pace of tightening seen so far, with previous hikes in June and September.

Why it matters

The potential signal that inflation has reached the 2% target is a watershed moment for the BOJ. After a long period of accommodative policies and efforts to combat deflation, achieving this goal marks a crucial transition in monetary strategy. It validates years of attempts and paves the way for monetary policy normalization.

This shift in narrative is key for future expectations. If the BOJ becomes more comfortable stating that inflation is around 2%, the debate will move from whether normalization is justified to how quickly rates should rise. This implies a gradual exit from an era of ultra-low interest rates, with significant implications for the cost of borrowing and the behavior of investors and businesses.

Market impact

• Interest rates and bonds: The signal that inflation has hit the target and the prospect of a December hike tend to pressure Japanese government bond yields higher as investors price in future monetary tightening. The Japanese Yen (JPY) may strengthen on the prospect of higher interest rates.
• Dollar and currency: Expectations that the BOJ might raise rates could lead to a strengthening of the Yen against other currencies, including the US Dollar. This could create selling pressure on the USD/JPY pair.
• Equities: The impact on Japanese equities is mixed. On one hand, monetary policy normalization can be seen as a sign of economic health. On the other hand, higher interest rates could increase companies' financing costs and reduce risk appetite.
• Commodities: Direct impact on commodities is less likely unless a stronger Yen affects global demand for Yen-denominated commodities or if Japanese monetary tightening has a significant effect on the global economy.
• Brazil: The direct impact on Brazil is limited. However, a stronger Yen could reduce capital flows to emerging markets seeking higher returns, and global monetary tightening, including from Japan, can influence risk appetite for Brazilian assets.

What to watch

Investors should closely monitor the BOJ's official communication at its October meeting, particularly the quarterly economic outlook report and statements from the governor. Confirmation of inflation around 2% and any signals about the future pace of monetary tightening will be crucial. Tracking Japanese inflation and wage data in the coming months will also be important to assess the sustainability of these trends.

Scenarios

• Base Case: The BOJ signals inflation has hit the target but adopts a cautious stance in October, with a rate hike confirmed for December. The Yen strengthens gradually.
• Risk Case: The BOJ surprises with a rate hike in October or signals a more aggressive tightening pace than expected, leading to a sharper Yen appreciation and greater volatility in global interest rate and currency markets.

Original source: ForexLive (InvestingLive). For information only, not investment advice.