By Leika Kihara
TOKYO (Reuters) -Japan’s election outcome may put the central bank in a double bind as prospects of big spending could keep inflation elevated while potentially prolonged political paralysis and a global trade war provide compelling reasons to go slow on rate hikes.
Lingering political uncertainty may also weaken the yen and push up import costs, some analysts say, adding to mounting price pressures that conflict with the Bank of Japan’s current approach to stand pat until the political storm calms.
The rising cost of living was among factors that led to the bruising defeat of Prime Minister Shigeru Ishiba’s ruling coalition in upper house elections on Sunday. With inflation holding above the BOJ’s 2% target for over three years now, some BOJ board members have already warned of growing price pressure.
Junko Koeda recently argued for the need to monitor second-round effects from rising rice costs. Another board member, Hajime Takata, said this month the BOJ must resume rate hikes after a temporary pause as Japan was on the cusp of achieving the bank’s 2% target.
“If upward inflation risks heighten, the BOJ may need to act decisively as a guardian of price stability,” its hawkish policymaker Naoki Tamura said late last month.
Now a minority in both chambers of parliament, Ishiba’s ruling camp must compromise with opposition parties, which have called for tax cuts and bigger spending, to pass legislation.
In a nod to such calls, Ishiba said on Monday he would stay on as prime minister and work with other parties on measures to cushion the blow to households from rising inflation.
While a cut to the consumption tax would leave a huge hole in Japan’s worsening finances, doing so would require passing legislation through parliament and take time.
More likely would be for Japan to compile an extra budget in autumn to fund payouts and tax breaks. The size could exceed last year’s 14-trillion-yen ($95 billion) package given heightening opposition demands for bolder steps, analysts say.
“A supplemental budget this fall to help firms cope with U.S. tariffs was expected even before the vote. Now, opposition parties may demand a larger package,” said David Boling, a director at consulting firm Eurasia Group.
YEN MOVES KEY
To be sure, Japan’s economy may need the fiscal boost after shrinking in the first quarter and seen taking a hit from U.S. tariffs that are already hurting its mainstay automobile sector.
But market worries over Japan’s huge debt and political instability could weaken the yen, and cast doubt on the BOJ’s view cost-push pressure will ease later this year, analysts say.
“With Ishiba signaling his resolve to stay on as premier, markets are now in a wait-and-see mood. But that doesn’t mean the chance of yen declines has disappeared, as the election definitely weakened administration’s standings,” said Tsuyoshi Ueno, an economist at NLI Research Institute.
Unlike other major economies, Japan’s inflation-adjusted real interest rates remain deeply negative due to the slow pace at which the BOJ rolled back a decade-long, massive stimulus.
After raising short-term interest rates to 0.5% in January, Governor Kazuo Ueda has signaled a pause in rate hikes until there is more clarity on the economic impact of U.S. tariffs.
Given the risk from U.S. tariffs, many analysts now expect no rate hike for the rest of this year. But staff BOJ estimates suggest its policy rate must rise at least to 1% to reach levels that neither stimulates nor cools growth.
In the end, a renewed yen decline could be the next decisive nudge towards further rate hikes, some analysts say.
Although the BOJ is guaranteed by law independence from government interference, it has historically been sensitive to political developments. Its massive stimulus in 2013 was deployed after intense pressure from then premier Shinzo Abe to reverse a strong yen and beat deflation.
The BOJ’s exit from ultra-loose policy last year came after a flurry of calls from politicians to help stem sharp yen falls that were pushing up import costs.
“For the BOJ, the biggest concern is how the election could change the government’s focus on economic policy, and how markets could react,” said a source familiar with its thinking.
Veteran BOJ watcher Mari Iwashita sees the chance of a rate hike in October if the yen, now around 147 to the dollar, falls below 150 and puts upward pressure on prices.
“Sustained yen weakness would push up underlying inflation, so could be a key trigger for policy action,” said Iwashita, who is executive rates strategist at Nomura Securities.
($1 = 147.4300 yen)
(Reporting by Leika Kihara; Editing by Sam Holmes)
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