What Japan’s interest rate hikes mean for international trade and investment

After a prolonged deflationary trend, the Japanese economy entered a rising prices era, tracking global inflation due to a global supply shortage and rising demand in the aftermath of the COVID-19 pandemic. Unlike other major central banks such as the US Federal Reserve that implemented multiple interest rate hikes to temper inflation, Japan – a major player in the international financial market – remained one of the few countries that kept its interest rates low. The Bank of Japan (BOJ) deemed it fit to ensure the country’s post-pandemic economic recovery even when inflation rates continued to surge, together with a depreciating yen.

In a major turnaround, the BOJ ended its negative interest rate regime during its March 2024 monetary policy meeting, raising interest rates within a 0 to 0.1 per cent range, making it the first short-term rate hike since 2007. This decision was anticipated by the market since the BOJ hinted in January that the conditions for exiting negative interest rates are being satisfied. In particular, the central bank indicated that its prolonged yield curve control, broad monetary easing measures, and negative interest rate policies have produced the desired results of stimulating economic activity.

Contrary to the convention of raising interest rates to rein in inflation, the BOJ aimed for its new monetary policy framework to bring inflation towards its price stability target of 2 per cent after months in negative territory, or when prices of basic goods were declining year-on-year.

Japan’s inflation rate soared beyond that target, reaching 4.3 per cent in January 2023 before cooling to 2.7 per cent in March 2024. Despite the March interest rate hike, however, inflation continued to float above the policymakers’ target and plateaued at 2.8 per cent in May-July. As a result, the BOJ raised the short-term rate to 0.25 per cent during its July policy meeting in response to the continued depreciation of the yen against the US dollar and mounting pressure to provide some relief to consumers. How will these rate hikes affect the Japanese economy?

Exchange rate and trade dynamics

The yen has generally depreciated against the US dollar over the past four years. From a monthly average of JPY 103.74 per USD 1 in January 2021, the local currency slid to JPY 149.85 to USD 1 at the start of October 2024. The prolonged depreciation of the yen led to the BOJ’s decision to keep interest rates low while monitoring the economy’s gradual pick up. In addition, inflation continued to surge past the 2 per cent target due to high import costs, especially for food and energy where Japan is a net importer.

While a few large manufacturers have benefited from the weak yen by earning more from their products sold abroad, small- and medium-sized businesses with limited global reach have struggled to capitalize on this advantage. Yet, the increasing globalization among Japanese manufacturers has limited the accrued benefit from a weaker yen. Since 1990, there has been an increase in internationalization by about 19.2 percentage points. Graph 1 further depicts Japan’s trade balance largely in deficit despite the continuous decline of its currency, suggesting an underutilization of its export price competitiveness.

By raising interest rates to 0.25 per cent in July, the yen appreciated to 149.55 on 1 August and to 146.12 on 23 August, about the same rate as in September 2023. This sudden hike could potentially reduce import costs while further depressing export values. Changes in import and export values after the March hike provide a clue regarding its potential effect. For instance, the trade deficit widened in April and May before reversing to a surplus in June. One can expect the larger July rate hike to have a bigger trade deficit effect, although only for the short term.

Wage increase, future hikes

The BOJ’s rate hike has been bolstered by positive outcomes from wage negotiations between labour unions and companies in Japan. This year’s saw the average wage rising by 4.45 to 5.1 per cent. The BOJ anticipates higher salaries to augment household expenditure amid rising prices.

Graph 2 depicts the downward trend in both nominal and real consumer spending until February. Since then, there has been an improvement in consumer spending, which has encouraged the BOJ’s policy shift. With the positive consumption-price dynamics, it is feasible that the BOJ will achieve its 2 per cent inflation target and keep the Japanese economy on a steady inflation state.

The wage hike, coupled with the potential pickup in domestic demand amid a weak yen, still begs the question of whether the BOJ will consider raising rates in its subsequent monetary policy meetings. Following the massive stock market decline after the July hike, BOJ Deputy Governor Shinichi Uchida said there will be no further hikes during an unstable market, a statement likely aimed at calming the market. However, BOJ Governor Kazuo Ueda defended the rate adjustment as the best move given the state of Japan’s economy. It seemed like another hike may be in the horizon if inflation remains above target.

This outlook presents both a caution and opportunity to investors. On one hand, investors engaged in carry trade, or those borrowing in yen to invest in the stock market at a low interest rate, should be cautious of future rate hikes that could increase repayment costs. Rising wages, on the other hand, could spur domestic demand. This will benefit retail sectors and raise the stock prices of domestic manufacturers.