The Bank of Japan is reportedly considering raising interest rates in June and may implement another hike within the same year, signaling a new phase in the normalization of its monetary policy.

According to reports, officials at the Japanese central bank may discuss a proposal to increase the benchmark rate by 25 basis points to 1% at their policy meeting concluding on June 16. Officials believe there remains room for further rate hikes beyond this, citing that real interest rates are still low and upside risks to inflation persist. In response to this news, the overnight swap market has priced in an 88% probability of a rate hike at this meeting.

Key Factors Driving the Decision

This potential move follows clear signals from Bank of Japan Governor Kazuo Ueda in his final public remarks before the meeting. He indicated that the central bank would need to consider raising interest rates if the risk of inflation exceeding expectations due to the Middle East conflict outweighs its negative impact on the economy. Concurrently, the yen has remained persistently weak. Since late April, Japan has reportedly spent approximately $74 billion on market interventions to support the currency, further strengthening market expectations for action from the central bank.

Reports citing informed sources suggest that while officials will seriously weigh the rate hike options at the upcoming meeting, the high uncertainty surrounding the Middle East situation means they will likely gather as much data and information as possible before making a final decision. Some opposition to a hike is expected within the meeting, but it is not anticipated to be sufficient to alter the final outcome. Governor Ueda faced three dissenting votes against a hike at the April meeting, but two other board members have since publicly expressed support for further policy normalization. This suggests that if he decides to proceed with a hike, he could secure majority support within the nine-member policy board.

Adjustments to Bond Purchase Program

Another focal point of the meeting will be the Bank of Japan's plan to reduce its bond purchases. Currently, the bank is trimming its buying by ¥200 billion (approximately $1.3 billion) per quarter, a schedule set to run until March next year. Sources indicate that officials see little necessity to maintain this pace of reduction starting from April next year. Given that the functionality of the Japanese government bond market has improved, policymakers may consider slowing the pace of reduction or even pausing it. Officials believe that with market functioning normalizing, the specific pace of tapering has become relatively less critical.

Market Expectations and Pricing

Market expectations for a rate hike have been largely priced in, with the overnight swap market indicating an 88% probability for a move on June 16. Beyond inflation, the trajectory of the yen is a core variable for the market. The currency has recently hovered around the 160 level against the U.S. dollar, a zone that triggered Japan's massive currency interventions. Governor Ueda's explicit pre-meeting comments, stating the need to consider a hike if inflation risks outweigh economic damage, have been interpreted by the market as a strong policy signal.