BOJ stays put as the economy faces mounting risks

What’s happened?

The monetary policy committee of the Bank of Japan (BOJ, the central bank) voted overwhelmingly (by eight to one) to keep the policy rate unchanged at 0.25% at a meeting that concluded on December 19th. This followed its historic exit from the negative interest rate in March 2024 and an increase in its policy rate from 0% to 0.25% in July 2024, after a prolonged period of ultra-accommodative monetary policy.

Why does it matter?

The BOJ’s decision to stay on hold this time does not spell the end of its normalisation. Instead, EIU expects the central bank to raise its policy rate by 25 basis points in January 2025, in the first of two quarter-percentage-point increases across the year. However, the central bank will maintain a cautious approach, ready to pause monetary normalisation, as it recognises that the real economy needs room to adjust to higher interest rates.

The risks facing Japan’s economy are multifold. On one hand, the economy has recovered modestly, with some incipient signs of improving private consumption despite persistent inflation. Employment and income have been on a mild improving trend, and expectations for inflation remain elevated. On the other hand, there are pockets of weakness in the economy. Global uncertainty is on the rise, and this appears to be affecting business sentiment with regard to recruitment and spending plans for 2025.

Domestically, the rise in political uncertainty will hold back business and household confidence and is negative for the effectiveness of government policy. The fact that the government introduced a large fiscal stimulus package in November indicates that it is aware of the substantial downside risk.

In our view, the Japanese economy has performed better recently than it had done in the recent past, having exited deflation and with plenty of signs of green shoots. However, an aggressive normalisation of monetary policy that brings about a rapid rise in interest rates could spoil the party.

Hence, the BOJ will remain cautious, to prevent its policy normalisation from causing an economic recession or undermining its success in reflating the economy. The pace of interest-rate increases will depend largely on the strength and durability of wage growth, as the central bank aims to cultivate a positive growth cycle driven by consumption in the private sector, which is not yet assured.

What next?

Based on our baseline forecast, which expects 0.8% GDP growth and 2.2% average inflation in 2025, we believe that the BOJ will lift the policy rate to 0.75% by year-end, from 0.25% at end-2024. The central bank will also unwind its quantitative easing and reduce the size of its balance sheet by scaling back its purchase of ten-year government bonds and exchange-traded funds. This will offer some support for the yen, which has weakened considerably in 2024. However, we continue to believe that the key risk to this scenario could come from heightened global risks that could affect the manufacturing sector and job market in Japan. Any signs of growth falling sharply below the baseline would persuade the BOJ to slow its monetary normalisation.

The analysis and forecasts presented in this article are drawn from EIU’s Country Analysis service. This comprehensive solution offers essential insights into the political and economic outlook of nearly 200 countries, empowering businesses to manage risks and develop effective strategies.