Shrinking economy in Japan casts doubt on BoJ rate raise bets

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Japanese markets were rocked for a second day by speculation that the country’s central bank will soon scrap its longstanding policy of holding interest rates below zero.

But economists warned that it was premature to expect any bold tightening move by the Bank of Japan later this month after fresh government data showed that the economy had contracted more sharply than initially expected in the third quarter.

On Thursday, the yen shot to a four-month high of ¥141.6, after Bank of Japan governor Kazuo Ueda said an “even more challenging year” was ahead. On Friday, it pared back some gains to trade around ¥143.

The Topix dropped 1.5 per cent while government borrowing costs hit their highest in three weeks as bond prices continued to fall.

After Ueda’s remarks, which were made before a meeting with Japanese Prime Minister Fumio Kishida on Thursday, the implied probability of a rate rise when the BoJ holds its next meeting on December 19 rose to 35 per cent, according to Société Générale analysts.

Investors were already expecting the BoJ to raise short-term interest rates, which are currently at minus 0.1 per cent, by next spring on the back of rising inflation and signals of further wage increases by Japanese companies. Core consumer prices have exceeded the BoJ’s 2 per cent target since April 2022.

In October, the central bank decided to allow yields on the 10-year Japanese government bond to rise above 1 per cent, a step towards ending its seven-year policy of capping long-term interest rates.

However, economists said that the central bank was confronting growing headwinds to unwind its easing measures with a stronger yen, a slowing economy and rising bets for less aggressive monetary policy by the Federal Reserve.

Japan’s gross domestic product declined 2.9 per cent on an annualised basis in the third quarter, compared with a previously estimated 2.1 per cent contraction, according to revised figures released by the cabinet office on Friday. 

The reading translated into a 0.7 per cent contraction on a quarterly basis, underscoring a struggling economy as household consumption remained weak. Historically, a stronger yen also weighs on export-dependent Japanese companies by making Japanese goods more expensive for foreign buyers.

Masamichi Adachi, chief Japan economist at UBS Securities, said the BoJ would probably be cautious because of the contraction in the Japanese economy and the uncertainty surrounding the US economy and the potential for the Fed’s rate cuts.

“Investors seized on [Ueda’s] comments since they wanted volatility and a catalyst to move since they had already expected a strong yen and a weaker dollar,” Adachi said. “But if you look at the macroeconomic conditions, it’s nearly impossible for the BoJ to raise rates in December.”

Citigroup economist Katsuhiko Aiba also said he expected the BoJ to maintain its current monetary policy in the December and January meetings.

“We believe that termination (of negative interest rates) will be based on economic and price fundamentals and today’s second print for third-quarter GDP provides no justification on fundamental grounds,” Aiba wrote in a report. 

In addition to the weaker economic outlook, the domestic political situation was also unstable, with rising doubt over whether Kishida can survive an expanding political funding scandal. 

On Friday, chief cabinet secretary Hirokazu Matsuno said he wanted to continue to serve in his post following media allegations that he did not declare ¥10mn ($69,000) in political donations as part of a wider funding scandal involving factions within the ruling Liberal Democratic party.