Bank of Japan must weigh Trump trade threats as it tightens policy

A weaker yen is typically good for Japanese exporters but could push inflation higher because the country imports much of its energy and food. Photo: Kiyoshi Ota/Bloomberg News
A weaker yen is typically good for Japanese exporters but could push inflation higher because the country imports much of its energy and food. Photo: Kiyoshi Ota/Bloomberg News

Summary

Setting rates in Japan will become a delicate balancing act if tariffs materialize.

A weaker yen is typically good for Japanese exporters but could push inflation higher because the country imports much of its energy and food.

The Bank of Japankicked off a global market selloff last time it raised interest rates. The likely rate increase this week will be less dramatic, but the real suspense lies in what comes next for the yen.

Japan’s central bank looks poised to lift its key interest rate to 0.5%, from 0.25%, at its meeting Thursday and Friday, according to around 80% of economists polled by Reuters.

The move would push borrowing costs to levels not seen since the 2008-09 financial crisis. Strong wage growth and persistent inflation above 2% have finally convinced the BOJ that Japan’s economy can handle gradual tightening. Japanese companies gave an average pay rise of 5.1% last year, the largest increase in 33 years.

The last rate increase in late July from the BOJ, which at the time coincided with a weak monthly jobs reading in the U.S., sent seismic waves across the globe—the Topix lost 20% in three days in early August while the Nasdaq also dropped 8% over the same period. The unwinding of so-called carry trades—borrowing in cheap yen to chase higher yields elsewhere—seems to have been the culprit.

But BOJ officials have learned their lessons. They have carefully telegraphed their intentions in recent weeks, preventing a nasty surprise like last time. While the market had long expected the BOJ to raise rates last year, unexpectedly hawkish rhetoric in the July meeting sent the Japanese yen sharply higher.

Graphic: WSJ
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Graphic: WSJ

What is more, a big part of those carry trades seem to have been unwound already. While bets against the Japanese yen have ticked up in the past month or so, likely because of reduced expectations of rate cuts in the U.S., the amount outstanding is still only half the level of last summer. Leveraged funds’ net short position in options and futures against the yen as of last week was around ¥708 billion in notional value, the equivalent of $4.5 billion. That compares with around ¥1.4 trillion in early July.

A gradual approach to rate increases shouldn’t rattle Japanese markets much, with investors expecting just one more 0.25% increase this year. The real drama lies elsewhere: Currency swings could hit Japanese exporters like Toyota hard if the yen strengthens too much.

What happens next may depend more on Washington than Tokyo. While President Trump’s threatened tariffs haven’t materialized yet, U.S. trade policy remains a wild card. Trump’s proposed policies like tariffs and tax cuts could reignite inflation in the U.S., forcing the Federal Reserve to slow its pace of rate cuts. That would in turn push up the dollar—and hence weaken the yen.

A weaker yen is typically good for exporters, but that could be cold comfort if it resulted from broader trade disruptions. And a weaker yen could push up inflation in Japan given the country imports much of its energy and food. That may also raise production costs from imported raw materials. That means BOJ would face a dilemma: Let the yen fall and possibly worsen inflation, or tighten harder which could strengthen the yen and exacerbate an already difficult trade situation.

For now, BOJ Gov. Kazuo Ueda will probably proceed with caution. After this well-telegraphed rate hike, some curveballs could be coming from across the Pacific.

Write to Jacky Wong at jacky.wong@wsj.com

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