What’s Next for Japan After Rate Hike?

The Bank of Japan jolted global markets after its recent decision to raise interest rates. Our experts break down the effects the move could have on the country’s economy, currency and stock market.

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Chetan Ahya: Welcome to Thoughts on the Market. I'm Chetan Ahya, Morgan Stanley's Chief Asia Economist.

Daniel Blake: And I'm Daniel Blake, from the Asia Pacific and Emerging Market Equity Strategy Team.

Chetan Ahya: On this episode of the podcast, we will cover a topic that has been a big concern for global investors: Japan's rate hike and its effect on markets.

It's Thursday, August 22nd at 6pm in Hong Kong.

On July 31st, Japan's central bank made a bold move. For only the second time in 17 years, it raised interest rates. It lifted its benchmark rates to around 0.25 percent from its previous range of 0 to 0.1 percent. And at the press conference, BOJ Governor Ueda struck a more hawkish tone on the BOJ rate path than markets anticipated. Compounded with investors concern about US growth, this move jolted global equity markets and bond markets. The Japan equity market entered the quickest bear market in history. It lost 20 percent over three days.

Well, a lot has happened since early August. So, I'm here with Daniel to give you an update.

Daniel Blake: Chetan, before I can give you an update on what the market implications are of all this, let's make sense of what the macro-outlook is for Japan and what the Bank of Japan is really looking to achieve.

I know that following that July monetary policy meeting, we heard from Deputy Governor Uchida san, who said that the bank would not raise its policy rates while financial and capital markets remain unstable.

What is your view on the Bank of Japan policy outlook and the key macro-outlook for Japan more broadly?

Chetan Ahya: Well, firstly, I think the governor's comments in the July policy meeting were more hawkish than expected and after the market's volatility, deputy governor did come out and explain the BOJ's thought process more clearly. The most important point explained there was that they will not hike policy rates in an environment where markets are volatile -- and that has given the comfort to market that BOJ will not be taking up successive rate hikes in an early manner.

But ultimately when you're thinking about the outlook of BOJ's policy path, it will be determined by what happens to underlying wage growth and inflation trend. And on that front, wage growth has been accelerating. And we also think that inflation will be remaining at a moderate level and that will keep BOJ on the rate hike path, but those rate hikes will be taken up in a measured manner.

In our base case, we are expecting the BOJ to hike by 25 basis points in January policy meeting next year, with a risk that they could possibly hike early in December of this year.

Daniel Blake: And after an extended period of weakness, the Japanese yen appreciated sharply after the remarks. What drove this and what are the macro repercussions for the broader outlook?

Chetan Ahya: We think that the US growth scare from the weaker July nonfarm payroll data, alongside a hawkish BOJ Governor Ueda's comments, led markets to begin pricing in more policy rate convergence between the US and Japan. This resulted in unwinding of the yen carry trade and a rapid appreciation of yen against the dollar.

For now, our strategists believe that the near-term risk of further yen carry trade unwinding has lessened. We will closely watch the incoming US growth and labor market data for signs of the US slowdown and its impact on the yen. In the base case, our US Economics team continues to see a soft landing in the US and for the Fed to cut rates by three times this yea