By Leika Kihara
TOKYO (Reuters) -The appointment of a new Japanese prime minister next month could give the central bank more reasons to go slow on its next interest rate hike, especially if the next leader is wary of seeing borrowing costs rise too quickly.
While the Bank of Japan’s main concern remains domestic inflation and the economic hit from U.S. tariffs, uncertainty around who becomes next leader or what their policies might be adds a layer of risk to deliberations around monetary settings.
Prime Minister Shigeru Ishiba announced his decision to resign on Sunday after a string of election defeats including a July upper house poll. The focus has now shifted to who will replace him.
Japanese bond yields fell on Tuesday on reports Sanae Takaichi, a proponent of government stimulus and monetary easing, would run in the Liberal Democratic Party’s leadership race in October, which could make her the next prime minister.
“The resignation of Japan’s prime minister Ishiba and the unfolding leadership contest at the ruling LDP will likely deter the Bank of Japan from raising rates in October,” analysts at Evercore ISI wrote in a research note, adding they were pushing back their call for the next hike provisionally to January.
The departure of Ishiba, seen as a fiscal hawk who gave a nod to gradual BOJ rate hikes, pushed down the yen and bond yields as investors reduced bets of a near-term rate hike. Money markets now show about a 20% chance the BOJ will hike rates by the end of October, down from 46% odds a week ago.
The LDP will choose his successor in a vote on October 4, who will then seek parliament approval to become head of government. A new administration may not be formed until mid-October, creating an uneasy political vacuum ahead of the BOJ’s policy meeting on Oct. 29-30.
While the wider political uncertainty won’t derail the BOJ’s plan to continue raising rates gradually, it could affect the timing of the next hike, said three sources familiar with its thinking.
“The BOJ doesn’t need to hike in the midst of turbulence,” one of the sources said. “It is in no rush and has a free hand on the timing, as long as it gets another rate hike done possibly by early next year.”
“The key is whether the hit from U.S. tariffs on Japan’s economy would be within expectations, rather than what happens with politics,” another source said on the rate-hike timing.
FISCAL COMPLICATIONS
Who wins the race will also have a significant impact on the pace and timing of BOJ rate hikes, analysts say.
Conservative lawmaker Takaichi is one of the frontrunners and previously a strong advocate of “Abenomics”-style mix of fiscal and monetary stimulus of deceased premier Shinzo Abe. She stands out for her criticism of the BOJ’s rate hikes.
Another contender is Shinjiro Koizumi, a proponent of deregulation whose views on monetary policy are little known. Both were top candidates in the LDP leadership race in September 2024 with Takaichi winning the most votes in the first round, only to be defeated by Ishiba in the run-up.
There is uncertainty on whether Takaichi will do as well this time, with some of her political backers having lost their jobs or clout due to a scandal that hit the former Abe faction.
Even if she wins, Takaichi may need to water down calls for ultra-low rates with rising inflation, rather than the risk of deflation, now a bigger problem for the public, analysts say.
“Support for reflationist-minded lawmakers has shrunk within the LDP. As such, Takaichi will need to restrain her calls for reflationist policies to some extent to win broad support within the party,” said BNP Paribas chief Japan economist Ryutaro Kono.
Whoever ends up winning the leadership race would ultimately run a minority coalition and need support from opposition parties to pass the budget through parliament.
Small opposition parties seen as candidates for forming an alliance are against an early BOJ rate hike, or have called on the central bank to tread carefully in rolling back stimulus.
While politics may create hurdles for a near-term rate hike, growing calls from most candidates and opposition parties for bigger spending could require the BOJ to lift rates over the longer-term to tame inflationary pressures.
The worst-case scenario for policymakers would be a sustained, sharp rise in bond yields triggered by investors’ concern over Japan’s loss of fiscal discipline.
In such an event, the government may pressure the BOJ to halt its quantitative tightening (QT) plan and step into the market with emergency bond purchases, some analysts say.
Such a move would be a major setback in the BOJ’s efforts, which began last year, to gradually taper its huge bond buying.
All this would give the BOJ reason to sit on the sidelines until the political dust settles. But waiting too long also carries risks.
Inflation has held above the BOJ’s 2% target for three years, and price pressures have broadened beyond stubbornly high food costs as a tight labour market pushes up wages.
“The BOJ must be cautious. But it also understands that waiting too long is not without risk,” a third source said.
(Reporting by Leika Kihara; additional reporting by Takaya Yamaguchi, Kentaro Sugiyama and Satoshi Sugiyama; Editing by Sam Holmes)
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