Political Uncertainty and Japan’s Interest Rates

By Leika Kihara

TOKYO (Reuters) – The political uncertainty left by Prime Minister Fumio Kishida’s decision to step down will likely lead to a pause, rather than a full stop, to the Bank of Japan’s plan to raise interest rates steadily from near-zero levels.

Influence of Ruling Party Leadership Race

How long that pause could be will depend not just on how the ruling party leadership race plays out, but how market moves affect the political debate on the preferred pace of rate hikes, analysts say.

Kishida, who hand-picked Kazuo Ueda as BOJ governor last year, said on Wednesday he will not stand in his ruling Liberal Democratic Party’s (LDP) leadership race in September.

The BOJ worked closely with Kishida’s administration in preaching the benefits of higher wages. Days before the BOJ’s rate hike in July, Kishida said the central bank’s policy normalization would support Japan’s transition to a growth-driven economy, indicating his backing towards exiting ultra-low interest rates.

Political Vacuum and BOJ Efforts

Kishida’s departure leaves a political vacuum that heightens uncertainty on economic policy and complicates the BOJ’s efforts to steer a smooth exit from easy monetary conditions in coordination with the government.

Leading candidates have mostly endorsed gradual increases in Japan’s current ultra-low interest rates, partly as a means to keep sharp yen falls at bay.

Shigeru Ishiba, a frontrunner to succeed Kishida as the next LDP leader and thus premier, stated that the BOJ was “on the right policy track” in hiking rates gradually.

Other candidates, like party heavyweights Toshimitsu Motegi and Taro Kono, have also emphasized the need for higher interest rates and hawkish communication by the BOJ.

The only advocate of aggressive easing is dark horse candidate Sanae Takaichi, who belongs to a party group that supported former premier Shinzo Abe’s stimulus policies.

Mari Iwashita, a veteran BOJ watcher, noted, “Takaichi might be an exception, but most candidates don’t seem to be against the BOJ’s policy normalization. If so, there won’t be much disruption to the bank’s long-term rate hike path.”

Tensions Between Politics and BOJ

The BOJ is granted independence from government interference in setting monetary policy, but it historically faces political pressure to use its monetary easing tools to reflate the economy.

This pressure is partly driven by the government’s power to appoint BOJ board members, including the governor, which requires parliament approval.

With the weak yen intensifying the strain on households through rising living costs, many politicians will likely lean towards gradual rate hikes for now, analysts say.

Consequently, the BOJ will likely stay the course and keep raising rates – albeit at a slower pace than initially thought.

A survey by the Japan Center for Economic Research indicated economists projecting another rate hike by year-end.

Economic Indicators

The weak yen has been enemy No. 1 for many lawmakers, leading to less political pushback against rate hikes than in the past.

Data showing the economy rebounded in the second quarter on robust consumption justifies further rate hikes, analysts say.

The BOJ has too much to lose by abandoning a carefully crafted plan to roll back a decade-long radical stimulus program, which ended negative rates in March and increased short-term rates to 0.25% from 0-0.1% in July.

The BOJ remains a global outlier on monetary policy, maintaining ultra-low rates even as its U.S. and European counterparts hiked aggressively to combat inflation. Currently, the BOJ is raising rates while its peers have begun easing, still far from normalizing policy.

Governor Ueda stated that further rate hikes are necessary adjustments to excess monetary support, rather than full-fledged tightening – a stance he is likely to maintain.

However, the BOJ may pause rate hikes at the next policy meeting on Sept. 19-20 due to ongoing political developments, especially with the LDP leadership race.

Looking Ahead

The U.S. presidential election may also increase market volatility, potentially keeping the BOJ from acting at a subsequent rate review on Oct. 30-31, analysts say.

Toru Suehiro, chief economist at Daiwa Securities, noted, “The BOJ will hold off on rate hikes at least until December when Japanese and U.S. political events run their course.”

The BOJ would need time to build trust with the new prime minister, who may not be approved by parliament until November.

As an academic turned governor, Ueda has fewer associates in political circles, making smooth communication with the new administration challenging.

There is no guarantee that politicians will continue to support rate hikes if the yen’s downtrend reverses.

A spike in the yen, partly due to the BOJ’s July rate hike, prompted a drop in stock prices, forcing the central bank to backtrack on its hawkish communication.

Naomi Muguruma, chief bond strategist at Mitsubishi UFJ Morgan Stanley Securities, warned, “If the weak-yen tide reverses, some politicians may begin to question whether the BOJ needs to hike rates further.”