BoJ still has a bias to raise rates

At its meeting in May, the BoJ Policy Board voted unanimously to leave the policy rate unchanged at 0.5%. The BoJ has been gradually raising the policy rate since March 2024, when it exited its Negative Interest Rate policy. The tone of each meeting since then has implied a bias to continue to tighten policy, with hawkish comments from Governor Ueda, forecasts of inflation above target and GDP growth above potential.¹ Elevated uncertainty due to the Trump administration’s trade policy resulted in less hawkish rhetoric from the BoJ at its May meeting. 

The BoJ’s updated ‘Outlook for Economic Activity and Prices’ saw downward revisions to Policy Board members’ forecasts for average annual real gross domestic product (GDP) growth and core consumer price index (CPI) inflation (see Chart 1).² In addition, risks were viewed as being skewed to the downside.

Chart 1. BoJ forecasts (% change, year-on-year)

Source: Bank of Japan. Data as at 01 May 2025.

The downward revisions to the GDP outlook reflect Policy Board members’ expectations that the Trump administration’s trade policies will lead to a global slowdown resulting in lower exports and production in Japan. This will likely produce weaker inflationary pressures, hence the downward revisions to core CPI inflation forecasts.

The BoJ highlighted “extremely high uncertainties” regarding the outlook. The baseline scenario incorporates assumptions that trade negotiations will lead to some progress in reducing tariffs, and significant supply chain disruption will be avoided. At the current juncture these assumptions seem reasonable but it is too early to anticipate with any degree of certainty. The outlook will be impacted materially by developments in these factors and, as such, they will be monitored closely. 

Markets interpreted the BoJ meeting as confirming Trump’s policies will be a significant stumbling block in its path to policy normalisation. The yen fell from 142.36 against the US dollar on 29 April to 145.44 on 01 May, a 2.2% depreciation. In addition, the BoJ policy rate implied by futures contracts has fallen significantly since “Liberation Day” and there is now less than one rate increase fully priced in for the remainder of 2025 (see Chart 2).

Chart 2. Japanese 3-month rate implied in futures contracts (%)

Source: LSEG Data & Analytics and EFGAM. Data as at 02 May 2025.

However, there are reasons to believe the BoJ will still raise rates in 2025. The most compelling reason is that, as the BoJ highlights in its ‘Outlook for Economic Activity and Prices’ document, real interest rates (interest rates minus inflation) are at “significantly low levels”. 

Core CPI inflation jumped from 0.8% year-on-year to 2.1% year-on-year in April 2022, pushing the BoJ’s real policy rate down from -0.9% to -2.2%. Inflation continued to rise gradually after this, meaning that despite the BoJ raising its policy rate by a cumulative 60 basis points since April 2024, its real policy rate has remained significantly negative (see Chart 3). This provides space for the BoJ to continue to raise rates and keep an accommodative policy at the same time.

Chart 3. BoJ real policy rate (%)³

Source: LSEG Data & Analytics and EFGAM calculations. Data as at 02 May 2025.

In addition, although the BoJ is now expecting underlying inflation to slow in the short term, it still expects it to reach its price target. In his post-meeting press conference, Governor Ueda said “The timing for underlying inflation to converge toward 2% has been pushed back somewhat but that doesn’t mean the timing of further rate hikes will automatically be delayed by the same margin”. ⁴

If the outlook materialises as the BoJ anticipates, then it is still reasonable to expect the Policy Board to vote in favour of another 25 basis point rate increase in 2025. Since this is no longer priced in by markets, this could also lead to a reversal of the Japanese yen depreciation against the US dollar that took place in the days after the BoJ’s May meeting. Such a reversal would reflect the economic outlook both in Japan and in the US. 

Given the unpredictability of the Trump administration’s trade policy, it is also important to recognise that the future path of monetary policy is unusually uncertain. Developments in trade policy have the potential to significantly impact this path.

¹ Bank of Japan staff estimated Japan’s potential growth rate to be around 0.5%. It should be noted that this estimate could be subject to revision due to “high uncertainties over how factors such as advances in digitalization will affect the trends in productivity or labor supply”. 
² https://www.boj.or.jp/en/mopo/outlook/gor2504a.pdf
³ The BoJ real policy rate is calculated by subtracting year-on-year core (all items less fresh food) inflation from the BoJ policy rate (uncollateralized overnight call rate).
⁴ https://www.reuters.com/business/finance/boj-governor-uedas-comments-news-conference-2025-05-01/