BoJ still has a bias to raise rates

At its meeting in May, the BoJ Policy Board voted unanimously to leave the policy rate unchanged at 0.5%. The BoJ has been gradually raising the policy rate since March 2024, when it exited its Negative Interest Rate policy. The tone of each meeting since then has implied a bias to continue to tighten policy, with hawkish comments from Governor Ueda, forecasts of inflation above target and GDP growth above potential.¹ Elevated uncertainty due to the Trump administration’s trade policy resulted in less hawkish rhetoric from the BoJ at its May meeting.

The BoJ’s updated ‘Outlook for Economic Activity and Prices’ saw downward revisions to Policy Board members’ forecasts for average annual real gross domestic product (GDP) growth and core consumer price index (CPI) inflation (see Chart 1).² In addition, risks were viewed as being skewed to the downside.

The downward revisions to the GDP outlook reflect Policy Board members’ expectations that the Trump administration’s trade policies will lead to a global slowdown resulting in lower exports and production in Japan. This will likely produce weaker inflationary pressures, hence the downward revisions to core CPI inflation forecasts.

The BoJ highlighted “extremely high uncertainties” regarding the outlook. The baseline scenario incorporates assumptions that trade negotiations will lead to some progress in reducing tariffs, and significant supply chain disruption will be avoided. At the current juncture these assumptions seem reasonable but it is too early to anticipate with any degree of certainty. The outlook will be impacted materially by developments in these factors and, as such, they will be monitored closely.

Markets interpreted the BoJ meeting as confirming Trump’s policies will be a significant stumbling block in its path to policy normalisation. The yen fell from 142.36 against the US dollar on 29 April to 145.44 on 01 May, a 2.2% depreciation. In addition, the BoJ policy rate implied by futures contracts has fallen significantly since “Liberation Day” and there is now less than one rate increase fully priced in for the remainder of 2025 (see Chart 2).

However, there are reasons to believe the BoJ will still raise rates in 2025. The most compelling reason is that, as the BoJ highlights in its ‘Outlook for Economic Activity and Prices’ document, real interest rates (interest rates minus inflation) are at “significantly low levels”.

Core CPI inflation jumped from 0.8% year-on-year to 2.1% year-on-year in April 2022, pushing the BoJ’s real policy rate down from -0.9% to -2.2%. Inflation continued to rise gradually after this, meaning that despite the BoJ raising its policy rate by a cumulative 60 basis points since April 2024, its real policy rate has remained significantly negative (see Chart 3). This provides space for the BoJ to continue to raise rates and keep an accommodative policy at the same time.

In addition, although the BoJ is now expecting underlying inflation to slow in the short term, it still expects it to reach its price target. In his post-meeting press conference, Governor Ueda said “The timing for underlying inflation to converge toward 2% has been pushed back somewhat but that doesn’t mean the timing of further rate hikes will automatically be delayed by the same margin".⁴

If the outlook materialises as the BoJ anticipates, then it is still reasonable to expect the Policy Board to vote in favour of another 25 basis point rate increase in 2025. Since this is no longer priced in by markets, this could also lead to a reversal of the Japanese yen depreciation against the US dollar that took place in the days after the BoJ’s May meeting. Such a reversal would reflect the economic outlook both in Japan and in the US.

Given the unpredictability of the Trump administration’s trade policy, it is also important to recognise that the future path of monetary policy is unusually uncertain. Developments in trade policy have the potential to significantly impact this path.

¹ Bank of Japan staff estimated Japan’s potential growth rate to be around 0.5%. It should be noted that this estimate could be subject to revision due to “high uncertainties over how factors such as advances in digitalization will affect the trends in productivity or labor supply”.

² https://www.boj.or.jp/en/mopo/outlook/gor2504a.pdf

³ The BoJ real policy rate is calculated by subtracting year-on-year core (all items less fresh food) inflation from the BoJ policy rate (uncollateralized overnight call rate).

⁴ https://www.reuters.com/business/finance/boj-governor-uedas-comments-news-conference-2025-05-01/

What could interrupt the weaker US dollar trend?

In the short term, any steps taken by the US administration that help restore credibility, trust and predictability would likely support the dollar. If the underlying problem is market scepticism about the effectiveness and necessity of trade tariffs, any actions that calm this caution could be well received by markets. An announcement, perhaps in the next few days, that reduces market concerns about the economic repercussions could help stabilise the currency market. In the absence of such an announcement, it cannot be ruled out that the EURUSD exchange rate will rise towards 1.20 and the USDCHF exchange rate will fall towards 0.75. News over the weekend that mobile phones and laptops will be excluded from tariffs for the time being represent a step in the right direction.

Separately, some central banks, notably the European Central Bank and the Swiss National Bank (SNB), will be concerned both with the speed of the move in the dollar and also the extent of the decline. This may encourage both central banks to adopt a more dovish policy stance, which in the case of the SNB will likely include currency market interventions, to offset the disinflationary impact of a strong euro and Swiss franc.

The medium-term implications of the recent developments point to a reduced role for the US dollar within the international financial system, including a smaller share in central bank foreign currency reserves. However, this will play out over years as there is currently no credible alternative that could replace the dollar.

Our expectation is that following this period of adjustment and volatility, US dollar bilateral exchange rates will continue to be strongly influenced by business cycle fundamentals, including GDP growth, inflation, interest rates and the state of public finances. Ultimately, it will be the economic policies adopted by governments around the world in response to the Trump administration’s actions that will determine the medium-term trends on the currency market.

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