To avoid being led by the market and given the uncertainty in the economic outlook, the Bank of Japan may restore ambiguous policy guidance.
After the Bank of Japan issued a clear signal for interest rate hikes last week, it may revert to its usual ambiguous guidance when considering the ultimate tightening intensity, in order to maintain flexibility.
In December of last year, the Bank of Japan was somewhat clumsy in its communication, first keeping interest rates unchanged, which surprised investors, but then conveying a clear signal for a rate hike the following month, allowing the market to digest this information at 90% and respond calmly.
However, this approach may prove to be temporary. Analysts and those familiar with the thoughts of the Bank of Japan's decision-makers say that Japanese policymakers are concerned about being led by the market and are uncertain about how far the central bank can raise rates without cooling the economy.
Given the uncertainty of the economic outlook, policymakers hesitate to send clear signals before each meeting, and they lack confidence about a 'neutral' interest rate that would neither cool down nor overheat the economy.
After the Bank of Japan's interest rate decision in December caught the market off guard, Governor Ueda Kazuo stated that the uncertainty of U.S. economic policy before Trump returns to the White House is a key reason for avoiding interest rate hikes.
Ueda's comments were seen as dovish, pushing down the market's pricing for a January rate hike by the Bank of Japan from 70% to 46%.
In order to avoid shocking the market again, the Bank of Japan subsequently set the tone for January's rate hike, imitating the actions of Federal Reserve Chair Powell in August last year, when he clearly stated that a policy shift was imminent, announcing that 'it is time to adjust policy.'
The cost of improving policy transparency.
Ueda and his deputy, Aizawa Noriyuki, indicated the week before last Friday's interest rate hike that the Bank of Japan's committee would "discuss whether to raise interest rates"—effectively announcing in advance the decision to double the short-term interest rate to 0.5%.
"Without these comments, the interest rate hike in January would have been a huge surprise," said Naomi Muguruma, chief bond strategist at Mitsubishi UFJ Morgan Stanley Securities. "The Bank of Japan might have no choice."
When asked about these advance signals, Ueda said after the interest rate decision last Friday that they were simply "reminders" to the market that the committee would discuss the feasibility of changing policy at each interest rate review.
Although this strategy allowed the Bank of Japan to smoothly raise its policy interest rate to the highest level in 17 years, it came at a cost.
Analysts stated that the market may be too focused on the Bank of Japan's comments rather than reviewing economic and price data to determine the timing of the Bank's next interest rate hike.
In addition to making the Bank of Japan feel constrained, sending clear advance signals may also violate Japanese law, which stipulates that a committee of nine members must debate and sign off on interest rate decisions at each policy meeting.
"This raises some red flags," said a former policymaker when discussing the Bank of Japan's communication regarding last Friday's interest rate hike. "The market should serve as a guide for central banks to understand economic conditions. But if this practice continues, the Bank of Japan will only see its own shadow in the market."
Policy needs greater flexibility.
Another reason for the Bank of Japan to restore ambiguity is the uncertainty of the tightening endpoint.
Bank of Japan staff estimate that Japan's nominal neutral interest rate is between 1% and 2.5%. Although this has not been a factor so far with such a low policy rate, an additional two rate hikes would lower rates to the bottom of this range — many Analysts view it as the neutral rate.
In fact, while Ueda claims that the Bank of Japan is determined to continue raising rates, he provided almost no clues about the future pace or timing of rate hikes last Friday and stated that it is difficult to determine Japan's neutral interest rate in real time.
"Since the Bank of Japan does not know the exact position of the neutral interest rate, it must wait about six months after each rate hike to check the health of the economy," said Izuru Kato, chief economist at Totan Research. "Only after determining that the neutral interest rate is still far away will it raise rates again."
As the Bank of Japan continues to raise rates, other complex factors are also emerging, which may increase the challenge for the central bank in trying to convince the public to continue raising borrowing costs.
The Bank of Japan defended last Friday's rate hike on the grounds of the prospect of sustained wage growth, but there is uncertainty about whether Consumer can withstand the rising cost of living.
Trump's threat to raise tariffs could put pressure on Japan's export-dependent economy and business sentiment.
The hand of the Bank of Japan seems increasingly bound by the complicated task of managing price pressures, re-inflation efforts, and market expectations, said Frederic Neumann, Chief Asia Economist at HSBC, adding that the risks surrounding Trump’s policies cannot be ignored, and ‘these all translate into greater variability in the future policy interest rate path.’
Editor/ping