Analysis: Shadow of Abenomics Clouds BOJ’s Rate Hike Path

By Leika Kihara

TOKYO – Political uncertainty in Japan, coupled with the unexpected rise of a candidate favoring reflation in the ruling party leadership contest, may lead the central bank to adopt a more conservative approach on interest rate increases from their historically low levels.

The Bank of Japan (BOJ) has already moderated its communications regarding future interest rate hikes due to looming concerns over potential U.S. recession and volatile financial markets that are clouding the economic outlook.

A new element of complexity arises from the political landscape as the race to elect the new leader of the ruling Liberal Democratic Party (LDP) intensifies. This leader will subsequently assume the role of prime minister.

Sanae Takaichi, a 63-year-old supporter of the late former prime minister Shinzo Abe’s market-stimulating policies, has emerged as one of the three frontrunners out of nine candidates. Takaichi, who could potentially become Japan’s first female leader, has been a vocal opponent of further interest rate hikes.

"We’re currently witnessing cost-push inflation. It’s essential to maintain an accommodative monetary policy until real wages consistently show positive growth," Takaichi remarked to reporters on September 19. “Raising interest rates now would be illogical,” she further warned in an online interview, stating that such a move could risk plunging Japan back into deflation.

Recent opinion polls indicate that Takaichi, along with former defense minister Shigeru Ishiba and former environment minister Shinjiro Koizumi, leads the pack. However, analysts perceive Ishiba and Koizumi as having potential advantages over Takaichi, and the polls suggest a tight race.

"If Takaichi emerges victorious, expect an initial market reaction characterized by a decline in the yen as investors adjust to the possibility of postponed rate hikes," said Naomi Muguruma, chief bond strategist at Mitsubishi UFJ Morgan Stanley Securities.

RE-EMERGING DEFLATION CONCERNS

In 2013, the BOJ enacted aggressive stimulus measures under then-prime minister Abe, aiming to boost sluggish inflation towards the bank’s 2% target. As raw material costs rose and the job market tightened, the BOJ began unwinding these policies, raising rates to 0.25% in July under governor Kazuo Ueda.

The departure of Prime Minister Fumio Kishida, who appointed Ueda and generally supported the gradual reduction of monetary stimulus, presents challenges for the bank’s strategy moving forward, analysts note.

"Regardless of who wins the LDP race, the BOJ’s situation will not improve compared to the Kishida era," said Takahide Kiuchi, a former BOJ board member and current economist at Nomura Research Institute. "It would be incredibly difficult for the BOJ to raise rates if Takaichi wins."

Even if Takaichi does not ascend to the prime ministership, a strong performance in the leadership contest could position her for a crucial cabinet role, thereby exerting influence on the next prime minister, according to analysts. As the current economic security minister, she is supported by lawmakers and academics aligned with reflationist policies who were instrumental in shaping Abenomics.

Though Abe stepped down in 2020 and was tragically assassinated in 2022, his legacy continues to resonate among a segment of the LDP’s conservative base that still favors substantial spending and ultra-low interest rates, complicating efforts to wean the economy off heavy stimulus.

Despite the BOJ’s formal independence, it remains sensitive to political pressures regarding its policies. Historically, it has been a target of public frustration, particularly given the protracted economic stagnation stemming since the late 1990s, which many attribute to premature monetary tightening.

While only LDP party members and lawmakers will vote in the upcoming contest, public sentiment appears to favor Takaichi’s economic proposals. "She has clearly articulated the need to safeguard the country and invest in critical areas to stimulate economic growth and revive Japan," noted a 59-year-old resident from Osaka.

Acknowledging concerns over increasing borrowing costs, Ueda stated in a recent speech that Japan must "avoid returning to deflation." He expressed hope for effective communication with the new government, regardless of who leads the LDP.

Uncertainty also surrounds the positions of the other frontrunners regarding rate increases. Ishiba, who has previously criticized the BOJ’s negative interest rate policy, has emphasized the importance of completely exiting deflation. However, Koizumi’s stance on monetary policy remains largely unclear.

While Takaichi’s potential victory may pose challenges for the BOJ, the other candidates could similarly resist rate hikes if Japan encounters economic difficulties, such as a spiking yen or weakening global demand. "Many candidates support hikes to mitigate yen depreciation and rising inflation, but that perspective may shift if economic conditions worsen," Kiuchi added.