In the bustling world of global finance, the spotlight has turned to Japan as speculation swirls regarding the monetary policy stance of the Bank of Japan (BoJ). As the market grapples with expectations about the timing of the next interest rate hike, internal discussions at the central bank are heating upThese deliberations center around a crucial and potentially contentious question: how much can interest rates be raised without jeopardizing economic growth? This issue is anticipated to be front and center at the upcoming policy meeting.

Expectations are high that during this Thursday’s meeting, the BoJ will opt to pause any further interest rate hikesHowever, the bank's governor, Kazuo Ueda, is expected to provide an in-depth analysis of the bank's perspective on future rate hikesThis may offer valuable insight into the trajectory of Japan's monetary policy moving forward.

Recent estimates from BoJ staff suggest that there’s room to raise short-term rates to around 1% without negatively impacting economic expansion

Nevertheless, some members of the central bank have pointed to a recent dip in consumer spending as an indicator that rates might need to stay lower for longerSuch internal debates are significant as they will likely influence the pace of future interest rate adjustmentsThe BoJ has set a target of reaching a near-neutral policy rate by early 2027.

The consensus among analysts is leaning toward a forecast of an interest rate increase around March of next year, moving from the current 0.25% to a short-term rate of 0.50%. This step would represent a crucial stride toward achieving a neutral monetary position.

Former BoJ board member Takahide Kiuchi has predicted that once rates are lifted to 0.5%, the bank would adopt a more cautious approach to further rate increasesHis rationale is that any subsequent hikes would bring borrowing costs close to neutral levelsKiuchi articulated a belief that the BoJ's view of Japan's neutral rate is just below 1%. He anticipates an increase to 0.5% in January, followed by a likely rise to 0.75% around September

“As soon as rates hit 0.5%, the BoJ will shift to an empirical approach, closely monitoring the economic impact of each hike,” Kiuchi explained.

However, the concept of a neutral rate continues to come wrapped in uncertaintyEarlier this year, the BoJ began unwinding a decade-long aggressive stimulus program, initially boosting the short-term interest rate to 0.25% in July, fueled by expectations of achieving a sustained 2% inflation rateKazuo Ueda has previously noted that if economic recovery persists, the BoJ intends to elevate rates to a level that signifies neutrality—where monetary policy neither constricts nor expands the economy substantially.

According to internal estimates, Japan’s inflation-adjusted neutral rate hovers between -1% and +0.5%. A 2% inflation target means the BoJ could feasibly lift rates to around 1% without hindering economic growth

Reports suggest that the central bank forecasts a move toward the neutral rate by some point after October 2025.

However, ambiguity remains regarding the precise level of neutrality, primarily due to the lack of reliable historical data, as Japan has endured over two decades of near-zero interest ratesHawkish member Naoki Tamura suggested in September that the BoJ must raise rates to at least 1% by the end of next yearNevertheless, many colleagues remain silent on the matter of neutrality.

Insider perspectives reveal that some BoJ officials believe that Japan's neutral rate could fall below 1%, as sluggish economic growth and subdued inflation dampen the need for aggressive hikes despite persistently low borrowing costs.

Evidence of the BoJ’s cautious outlook can be seen in the recently reported data indicating that Japan's economy grew at an annualized rate of 1.2% in the three months leading up to September, a drop from the previous quarter’s 2.2%. Consumer spending also showed signs of fatigue with only a 0.7% increase.

Core inflation, which peaked at 4.2% in January 2023, has steadily declined, dipping to 2.3% in October

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Strikingly, there are scant indicators of persistent wage-driven price pressures, which could suggest a broader trend of moderating inflation expectationsAs a result of these economic indicators, as well as a slowdown in inflation pressures tied to import costs, internal discussions suggest that there’s no rush to hike rates aggressively within the BoJ.

If indeed Japan's neutral rate settles around 1%, it suggests that at least two rate hikes would be necessaryA lower estimate of the neutral rate could alleviate some of the pressures around frequent increasesA mere lift to a 0.5% short-term rate would place it at the highest level since 2007-2008, leading to questions about how the public would perceive the likelihood of gradual increases.

As these discussions unfold, insiders express concern: “If the neutral rate is lower than anticipated, the BoJ must proceed with caution; aggressive rate hikes could potentially cool down the economy.” This sentiment captures the delicate balance that the Bank of Japan must navigate as it considers its monetary policy shifts, keeping a watchful eye not just on domestic challenges, but also on the global economic landscape