The Bank of Japan is widely expected to raise its benchmark interest rate at its upcoming policy meeting, marking the first hike since last December. This move comes as policymakers grapple with heightened inflation risks, partly driven by prolonged Middle East conflicts. The market's focus will shift to the central bank's future interest rate trajectory and its plans for reducing bond purchases.

Governor Kazuo Ueda is expected to miss the meeting due to hospitalization, a first since he took office in April 2023. The BOJ stated that Ueda will convey his views via a written statement during the June meeting but will not participate in voting. Deputy Governor Ryozo Himino will serve as acting chair, while Deputy Governor Shinichi Uchida will host the post-meeting press conference.

Investors will watch whether Uchida, a veteran central banker seen as a key architect of the BOJ's policy framework over the past two decades, delivers more direct policy signals than the typically cautious and nuanced Ueda. "Especially in bond markets, investors have grown accustomed to Ueda's communication style—not just his words, but his expressions and the atmosphere he creates at press conferences," said Hiroshi Namioka, chief strategist at T&D Asset Management. "His absence could make it harder to gauge the BOJ's true intentions, potentially increasing uncertainty for bond and currency traders." However, Uchida might also provide clearer guidance on the future rate path compared to Ueda's balanced approach.

If the BOJ hikes as expected, the key question for markets will be how quickly it might act next, a factor that will significantly influence currency markets post-decision. "A 25-basis-point hike is almost a done deal. The bigger question for markets is how Uchida will handle the press conference," said Carol Kong, a currency strategist at Commonwealth Bank of Australia. "A hike would help bolster confidence in the BOJ's independence and buy policymakers more time to assess when to hike next."

Bond Purchase Reduction Plan

The other major focus is the BOJ's bond purchase reduction plan. The central bank is currently reducing its bond buying by 200 billion yen per quarter, a pace set to continue until March next year. Last year, the BOJ halved the reduction speed due to concerns about disrupting the bond market. Despite the ongoing cuts, after over a decade of massive asset purchases, the BOJ still holds roughly half of Japan's outstanding government bonds. In May, the yield on Japan's 10-year government bonds hit its highest level since 1996, highlighting increased market volatility.

Earlier this month, Ueda indicated that policymakers would consider both improved market function and market stability when formulating future bond purchase plans. As bond market conditions improve, officials may discuss further slowing the reduction pace or even pausing the tapering process. Sources have indicated the BOJ is considering keeping its current government bond purchase size unchanged beyond the next fiscal year, effectively pausing the reduction. Four sources noted that, given progress in shrinking its massive balance sheet, the BOJ is leaning towards pausing the tapering. One source stated, "Even if the BOJ stops further reductions, the size of its bond holdings will still decline significantly just from bonds maturing."

The other sources expressed similar views, suggesting the BOJ might stop setting annual reduction targets and instead adopt an open-ended arrangement, committing to monthly purchases of around 2.1 trillion yen. "A key issue is how the BOJ will explain its bond purchase strategy while avoiding spooking the bond market or giving the impression it is yielding to fiscal policy considerations under the Takachi administration," said Seiji Adachi, chief economist at Rakuten Securities Economic Research Institute and a former BOJ official.

Sources suggest the decision to pause tapering could be a close call, as the BOJ's nine-member policy board is divided. Some members prioritize calming investor nerves, while others believe in steadily continuing reductions to shrink the BOJ's enormous balance sheet.

BOJ in a Tight Spot

The BOJ is facing a dilemma, according to Shigeto Nagai, head of Japan economics at Oxford Economics and former head of the BOJ's international department. On one hand, it must avoid antagonizing the government of Prime Minister Takachi, which is increasingly sensitive to the risks of premature monetary policy normalization. On the other, it must prove to investors it is not falling behind the curve as inflation risks rise and the yen weakens. "At some point, the BOJ may have to make a difficult choice between supporting domestic demand and preventing further yen depreciation," Nagai said.

Despite record government spending to support the yen, the currency remains near the key level of 160 yen per dollar, a threshold that has previously triggered intervention. For a resource-importing nation like Japan, a weak currency exacerbates inflationary pressures. External pressures are also mounting. The European Central Bank became the first major central bank to hike rates since the US-Iran conflict began, and traders increasingly believe the US Federal Reserve may tighten policy further before year-end. In this context, it is becoming harder for the BOJ to maintain dovish signals, as that could further weigh on the yen. Even with a hike to 1%, Japan's policy rate would remain among the lowest in the developed world.

"As other major central banks shift towards rate hikes, yield differentials could once again become a key driver of yen weakness, as they were in 2022, increasing upside inflation risks," said Taro Kimura of Bloomberg Economics. At the April policy meeting, Ueda faced three dissenting votes in favor of a hike, the largest split under his leadership. Since then, two members who voted to keep rates steady have publicly expressed support for a hike. In his last public remarks before the June meeting, Ueda strongly hinted that a hike was likely, stating that authorities would address inflation as price risks appear more urgent than downside economic risks. "Based on current data and information, upside price risks generally seem larger and may materialize more quickly," he said.

Investors will also watch for any dissent against a June hike. As the first policy board member nominated by Prime Minister Takachi, Toshiro Asada may lean towards supporting easier policy to reflect the Prime Minister's stance. One argument against a June hike is recent weaker inflation data, which currently sits below the BOJ's 2% target due to government subsidies. However, the BOJ expects inflation to reaccelerate later this year as energy cost increases from the Middle East conflict feed through the economy. Ueda has stated consumer price growth could exceed 3% this fiscal year. Investors also anticipate higher inflation. Japan's 10-year breakeven inflation rate—reflecting bond investors' expectations for average consumer price growth over the next decade—rose to a record 2.35% last month and has remained near that level, as rising oil prices combine with a weak yen to push inflation pressures higher.