Fiscal stimulus counterproductive? Former Bank of Japan official warns: interest rate hikes may exceed expectations, rates will reach 1.5%
A former member of the Bank of Japan expects that under Kazuo Ueda's tenure, there may be three more interest rate hikes to 1.5%, with the next rate hike window in June or July next year. Although the central bank is returning to a neutral interest rate (around 1.75%), the future pace is constrained by economic and political resistance between the U.S. and Japan. He warned that the government's aggressive fiscal expansion could exacerbate inflation and damage credibility, leading to yen depreciation and turmoil in the bond market, thereby disrupting the normalization process of policies
Former Bank of Japan Policy Board member Makoto Sakurai stated on Monday that during the remaining term of Bank of Japan Governor Kazuo Ueda until early 2028, the central bank may raise interest rates further three times, pushing the rate up to 1.5%. He also warned that the government's aggressive fiscal spending plans could backfire due to heightened inflation.
Makoto Sakurai expects that the next interest rate hike by the Bank of Japan may occur in June or July next year, at which point the rate will rise to 1.0%. The specific timing of the rate hike will depend on the strength of the U.S. economy and the latest developments in domestic wages and prices in Japan.
He pointed out that although the Bank of Japan has not publicly stated its position, it may internally estimate the neutral interest rate level to be around 1.75%. Raising the rate to 1.5% would keep it below that level while allowing enough room for future rate cuts. However, as borrowing costs approach this neutral level, which neither stimulates nor suppresses the economy, further rate hikes will face greater challenges.
Regarding market volatility, Makoto Sakurai warned that the government's large spending plan aimed at alleviating cost-of-living pressures could have the opposite effect. He believes that the recent sell-off of the yen is not solely due to interest rate expectations but more reflects market concerns about the erosion of fiscal credibility due to Japan's expansionary fiscal policy, which could lead to soaring bond yields and further depreciation of the yen.
Path to a 1.5% Interest Rate
According to Makoto Sakurai's analysis, during Kazuo Ueda's five-year term ending in April 2028, the ultimate target for interest rates will point to 1.5%. If the U.S. economy grows robustly and supports the Japanese economy, while domestic inflation remains above the central bank's 2% target, the Bank of Japan may implement two rate hikes in the next fiscal year starting in April 2026.
However, if uncertainties regarding the U.S. economic outlook increase and domestic inflation significantly slows, the central bank may choose to raise rates only once in the 2026 fiscal year and postpone subsequent actions until 2027. Makoto Sakurai stated that while the central bank may wish to resume a pace of rate hikes approximately every six months, it currently seems concerned about resistance from the government administration, which may explain the ambiguous stance expressed by Kazuo Ueda in previous communications.
Previously, the Bank of Japan raised the interest rate from 0.5% to 0.75% last Friday, a level of borrowing costs not seen in thirty years, marking a significant step in Japan's exit from decades of large-scale monetary easing policies. Although Kazuo Ueda indicated that the policy rate is still some distance from the lower bound of the neutral interest rate range (estimated at 1.0%-2.5%), he did not specify how many more rate hikes would be needed to reach the neutral level.
Political Resistance and Tightening Pace
As interest rates gradually approach the neutral level, the process of policy normalization may become more complicated. Makoto Sakurai revealed that the Bank of Japan's decision to raise rates to 0.75% last Friday may have already received approval from senior government officials, including Saemae Koichi and Finance Minister Satsuki Katayama "As long as the Prime Minister and the Chancellor of the Exchequer give their consent, there should be no problem with the Bank of Japan raising interest rates," Makoto Sakurai said in an interview:
"But as interest rates get closer to neutral levels, the situation may become complicated."
Further rate hikes could invite criticism from the inflationist advisors under Prime Minister Fumio Kishida, making subsequent policy adjustments face greater political maneuvering.
Fiscal Stimulus May Intensify Inflation Risks
Japan's inflation rate has exceeded the central bank's 2% target for nearly four consecutive years, with companies continuously passing on rising raw material costs to consumers and consistently responding to labor shortages through wage increases. Makoto Sakurai pointed out that the Bank of Japan's Tankan survey shows that companies expect inflation rates to reach 2.4% over the next year, three years, and five years, indicating that inflation is gradually taking root in the Japanese economy.
Against this backdrop, the large-scale spending plan introduced by the Kishida government, while aimed at cushioning the impact of rising living costs on households, carries the risk of accelerating inflation. Makoto Sakurai warned that the expansionary fiscal policy of the administration could undermine market confidence in Japan's fiscal situation.
He specifically mentioned that even after the Bank of Japan raises interest rates in December, the yen remains weak, indicating that the currency's weakness is more driven by market concerns over Japan's fiscal policy. Such concerns about fiscal discipline could trigger a sharp rise in bond yields and an undesirable decline in the yen's exchange rate, thereby offsetting the efforts of monetary policy to stabilize prices.
