The Japanese yen, which had fallen to its lowest levels in 38 years against the US dollar in July, is now trading near its highest levels of the year, driven by the Bank of Japan’s (BoJ) hawkish shift and expected rate cuts from the Fed.

Ahead of the July monetary policy meeting, the BoJ was caught between inflation and low consumer spending triggered by the weak yen, and the potential pressure a stronger yen could place on exports, leading to hesitancy about raising interest rates. However, at the July 31 meeting, after the yen's decline could not be halted despite interventions, the BoJ made a sharp hawkish turn by both raising interest rates and announcing a plan to reduce bond purchases.

Following the decision, the BoJ’s communication was criticized, but hawkish messages from BoJ officials persisted. Markets are not expecting any policy adjustments at tomorrow's meeting, but post-decision statements could be crucial for market projections regarding the BoJ's policy path.

Slower Growth and Persistent Inflation Shape Japan’s Economic Outlook

Growth data released last week revealed that Japan's economy grew at a slower pace in the second quarter of the year than initially estimated. Growth for the three months through June was reported at 2.9% quarter-on-quarter, below the initial forecast of 3.1%. The downward revision is attributed to lower figures in private consumption and capital investment.

Despite the downward revision in the latest data, growth remains well above the BoJ’s median 2024 forecast of 0.6%. Therefore, this revision is not significant enough to impact the BoJ’s hawkish stance.

On the other hand, consumer inflation in Japan has remained above the BoJ’s 2% target for 28 consecutive months, weighing on consumer demand. The July report revealed that household spending remained largely unchanged. Economists emphasize that domestic demand in Japan will become increasingly crucial, especially considering the potential cooling of demand from China and the U.S. and its possible impact on growth outlooks.

Data released Wednesday showed that Japan's export growth slowed. Exports rose 5.6% year-on-year in August, down from 10.2% the previous month. Shipments from Japan to the U.S. declined by 0.7%, marking the first drop in three years, while exports to Europe fell by 8.1%.

The slowdown in exports has clouded expectations for Japan’s economy. As the interest rate gap between the BoJ and the Fed narrows, the yen could strengthen, likely diminishing the performance of exporters who have benefited from a weak yen in recent years. In this scenario, domestic demand will become even more critical for Japan’s economic performance.

While real wages in Japan have stopped declining for the first time in over two years, consumer spending remains below pre-pandemic levels. Sustaining wage growth will be essential for demand recovery. Otherwise, this situation could influence the pace of the BoJ’s interest rate hikes.

No BoJ Adjustments Expected, But December Rate Hike Likely

All 53 economists surveyed by Bloomberg expect no adjustment from the BoJ at this meeting. However, around 70% of participants point to December as the timing for the next rate hike. While the possibility of an early move in October remains on the table, albeit unlikely, most economists predict that the BoJ will wait until December or January due to high market volatility.

On the other hand, futures markets are pricing in a 32% chance of another rate hike this year. Since market pricing lags behind economists' expectations, it is predicted that the yen could strengthen if a signal for another hike this year is given after the meeting.