Inflation has "largely met target," so why is the Bank of Japan still afraid to raise rates consecutively?

The Bank of Japan is approaching a critical juncture in the process of interest rate normalization. On Tuesday, according to people familiar with the matter, the central bank may signal this month that underlying inflation has largely reached the 2% target. This statement is more symbolic than an actual policy move, but it will significantly strengthen market pricing for a December rate hikeovernight index swaps have already pushed that probability up to 80%. The people said the Bank of Japan has begun emphasizing in its policy communication the need to anchor underlying inflation near the 2% target as the basis for judging the pace and timing of subsequent rate hikes. Recent data such as Tokyo consumer inflation and the central bank's quarterly "Tankan" corporate survey are strengthening policymakers' confidence that underlying inflation has "largely" reached the target, and the central bank may formally confirm this judgment in the quarterly report to be released after its October 29-30 meeting. If this signal materializes, it will be a landmark shift in the Bank of Japan's phrasing on its inflation target, clearing the precondition for another rate hike in December. The lesson from September, when the yen fell instead of rising after a rate hike, still lingers: policy actions lacking clearer guidance on the pace of tightening are hard-pressed to reverse yen weakness in the face of the U.S.-Japan interest rate differential. The gap between signal and action is precisely the core tension currently facing the Bank of Japan. The people stressed that the data are sufficient to support the central bank in confirming externally that the target has been "met," but not sufficient to persuade a majority of board members to hike rates back-to-back this month; government representatives have also unusually applied pressure, urging the central bank to carefully assess the cumulative effects of previous rate hikes. From "will meet target" to "largely meets target": a key step in wording In the quarterly report released in July this year, the Bank of Japan's wording was still that underlying inflation would reach a level consistent with the 2% target at some point before March 2028. By the September meeting minutes, some board members had already said that underlying inflation was "quite close" to 2%, or would hit it "soon." If "largely meets target" is formally confirmed this month, it will complete the shift in wording from "forward-looking expectation" to "confirmation of the current situation." One person said that "overall, price developments are in line with the Bank of Japan's projections," meaning underlying inflation is now roughly near target; another said that "inflation expectations remain elevated, but have not risen sharply." Such wording leaves room for a December rate hike while deliberately downplaying the urgency of immediate action. 80% pricing, and funds still shorting the yen Overnight index swaps show that the market-implied probability of a December rate hike has risen to 80%. After the two rate hikes in June and September, the market has broadly priced the Bank of Japan on a pace of one rate hike per quarter. The signals from fund flows are more complicated. Data from the U.S. Commodity Futures Trading Commission (CFTC) show that in the week ended September 29, leveraged funds turned back to net short positions in the yen, with bearish bets totaling about 210 billion yen (about $1.3 billion). Against the backdrop of consecutive rate hikes by the central bank, repeated warnings from the Japanese government about excessive yen depreciation, and U.S. Treasury Secretary Bessent publicly discussing "the desirability of a strong yen," speculative funds still chose to short, indicating that what the market is really trading is still whether the U.S.-Japan interest rate differential can narrow quickly, rather than whether the central bank will continue raising rates. Data enough to send a signal, not enough for back-to-back hikes Although the "Tankan" survey shows corporate inflation expectations remain high, they are moving sideways and have not heated up in a way that requires an immediate policy response, which to a considerable extent has lifted the burden on the central bank to hike consecutively this month. The 7-2 vote at the September meeting already exposed internal divisions, with two dovish board members casting opposing votes. The government's stance has further compressed the room for action this month. The September meeting minutes show that a Cabinet Office representative unusually urged the central bank to "carefully examine the cumulative effects of past rate hikes" and suggested incorporating estimates of the neutral interest rate into consideration. That statement temporarily cooled market expectations for a consecutive rate hike in October, and the yen subsequently fell below the 158 mark. The yen's constraint After the September rate hike, the yen fell instead of rising against the dollar, dropping more than 2% in a single week, with the dollar once rising to 157.53 yen. The yield on Japan's 10-year government bonds had previously touched 3%, the first time since 1996. The people noted that renewed yen weakness could increase pressure on the central bank to raise rates in October, but the pullback in U.S. rate hike expectations this month has partly offset that pressure, raising the probability that the Bank of Japan will hold steady in October. The wording of the quarterly report after the October 29-30 meeting will be the next key signal for judging whether a December rate hike can materialize. This article is reprinted from "Wallstreetcn," author: Zhao Ying; GMTEight editor: Xu Wenqiang.