Weekly Update - Bank of Japan: towards further policy normalisation

Lagging other developed economies, Japan is experiencing a period of high inflation and strong wage increases, putting an end to several decades of deflation. Against this backdrop, the Bank of Japan (BoJ) ended its negative interest rate policy a few weeks ago. Nevertheless, the rate hike was very moderate, which combined with expectations of fewer rate cuts in the United States, pushed the yen to its lowest level since 1990 against the dollar. The Japanese authorities seemed to have intervened recently, allowing the yen to stabilise. However, in order to support its currency in the long term, the BoJ will probably have to normalise its monetary policy more sharply in the months ahead.
 
A historic but limited pivot. In March, the Bank of Japan raised interest rates for the first time in 17 years. The central bank thus ended its negative interest rate policy, with rates moving from -0.1% to a range of 0% to 0.1%. The BoJ also abandoned its yield curve control (but may still intervene should bond yields increase too fast) and its purchases of risky assets. The BoJ is therefore beginning to normalise its policy. Nonetheless, not only was the rate hike smaller than markets expected, but Governor Ueda did not commit to further rate hikes in the future. There is no doubt that this caution was at least partly linked to memories of mid-2006, when the BoJ made a previous attempt to move away from zero interest rates, only to be forced to backtrack a few months later.
 
Emerging from deflation. Nevertheless, the situation today is different: inflation is much higher than in 2006 (2.7% year-on-year in March compared with 0.3% in July 2006) and the unemployment rate is much lower (2.6% in March compared with over 4% in 2006). Against this backdrop, wage growth has remained above 2% year-on-year for almost a year, compared with between 0.5% and 1% in the years pre-Covid. Meanwhile annual pay negotiations reached a 30-year high (5.3% increase for a fraction of employees). Japan thus appears to have turned the page on several decades of deflation, marked by average inflation and real growth (between 1995 and 2020) close to zero. This development should enable the BoJ to continue normalising its monetary policy.
 
More than one reason to raise rates. Recent developments in the yen could also play into the BoJ's hands in terms of further rate hikes. The interest rate differential between Japan and the United States is exerting strong downward pressure on the yen, which has lost almost 15% against the dollar since the start of the year (and 35% since the beginning of 2022), reaching its lowest level since 1990.In fact, the yen is clearly undervalued against the major currencies. Against this backdrop, the BoJ appears to have intervened recently on the foreign exchange market to limit the yen's depreciation, which could reinforce inflationary pressures. But further rate hikes by the BoJ would be far more effective in supporting the yen, allowing to both narrow the rate differential with the US or the euro area and help achieve its objective of stabilising inflation at 2%.
In the highlights of the week, we chose to talk about the Bank of England's monetary meeting  as well as corporate earnings in Europe and the United States: 
 
As expected by the markets, the Bank of England (BoE) left rates unchanged for the sixth time at 5.25%. Nonetheless, it sent out several signals pointing to a rate cut in the months ahead. Firstly, a second member (out of nine) of the Monetary Policy Committee voted in favour of a cut. Secondly, the BoE Governor, Mr Bailey, stressed that it was likely that the BoE would have to ease monetary policy, even more than the markets expect. Furthermore, he did not reject (nor validate) the possibility of a cut as early as June. Finally, the press statement stresses the importance of the data to be published between now and the next committees. Yet, inflation could fall back below the 2% target (at least temporarily) in May and June. Against this backdrop, the markets have raised their rate cuts expectations, with the first cut in June now expected with a probability of 60% (40% a week ago) and almost three cuts this year.
 
In a relatively quiet week in terms of data, the equity markets rebounded sharply this week, led by Europe and the United States, benefiting from the modest fall in interest rates for the second week running. The Japanese market, meanwhile, recorded another weekly fall. On the foreign exchange market, the dollar depreciated slightly against the euro but continued its rebound against the yen.
 

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