BOJ Rate Hike Outlook: US Trade Deal Creates Space, But Challenges Remain

Japan's Rate Hike Prospects After US Trade Deal

Sources suggest the trade deal between U.S. President Donald Trump and Japan may create room for the Bank of Japan (BOJ) to raise interest rates again this year. The BOJ might signal this by offering a less pessimistic assessment of the economic outlook.

However, four sources familiar with the BOJ's thinking indicate a rate hike is not a certainty in the short term. The timing depends on the economy's ability to withstand the impact of U.S. tariffs.

"With the cloud of U.S. trade policy clearing, the BOJ may see room to raise rates this year," one source said, a view echoed by two others.

"Not all trade-related uncertainties have been eliminated," a second source added, emphasizing the BOJ must carefully analyze data before autumn to judge the effect of U.S. tariffs on the economy.

Japan, the world's fourth-largest economy, has struggled with weak consumption, rising living costs, and a sluggish manufacturing sector.

Uncertainty surrounding the outcome of trade negotiations between Japan and the U.S. was among the reasons the BOJ downgraded its growth forecast in May and paused rate hikes.

But sources say the announcement of the U.S.-Japan trade agreement this week reduced uncertainty, removing a key obstacle to resuming rate hikes.

They suggest the BOJ might begin signaling a resumption of rate hikes – with a more optimistic assessment of the economic outlook compared to the current focus on risks stemming from tariffs.

BOJ Signals a Shift in Tone

Bank of Japan Deputy Governor Shinichi Uchida's remarks on Wednesday offered the first sign of this optimism. He stated the agreement increased the likelihood of Japan sustainably achieving its 2% inflation target – a prerequisite for further rate hikes.

"The BOJ needs to adjust monetary policy to better balance upside and downside risks," Uchida said, also highlighting inflationary pressures from rising food costs.

Uchida's upbeat comments contrast with Governor Kazuo Ueda's remarks in May, who said uncertainty over the BOJ's baseline scenario was "higher than before" due to tariff-related risks.

Sources indicate that at its next policy meeting on July 30-31, the BOJ will issue a quarterly report that may offer a more optimistic assessment of the impact of U.S. tariffs than before.

They also said the committee may raise its inflation forecast for this year and consider adjusting its current assessment that "risks to the price outlook are skewed to the downside."

"The trade agreement has paved the way for the BOJ to raise interest rates," said Ayako Fujita, an economist at JP Morgan Securities. "This provides a reason for the BOJ to raise its forecast." Fujita expects a rate hike in October.

Underlying Economic Challenges Remain

Although the BOJ is likely to keep rates unchanged next week, markets have begun pricing in the possibility of a near-term rate hike. The two-year Japanese government bond yield, most sensitive to interest rate expectations, touched a near four-month high of 0.845% on Thursday.

The BOJ last year exited a decade-long massive stimulus program and raised its short-term policy interest rate to 0.5% in January, citing that Japan was moving toward sustainably achieving its price target.

Despite core inflation having exceeded the 2% target for more than three years, the BOJ has been cautious about raising rates, fearing damage to the fragile economy.

Divisions exist within the committee on the timing of a rate hike. With real interest rates still deeply negative, hawks such as Naoki Tamura have warned of the risk of moving too slowly.

But sources said BOJ doves do not believe the economy is out of the woods, as risks remain.

Japan's economy shrank in the first quarter as rising living costs weighed on consumption, raising recession concerns.

Currently, the U.S. has not reached trade agreements with major destinations for Japanese exports. Although exports and output have remained stable, analysts expect the impact of tariffs will become more apparent in data over the coming months.

Takahide Kiuchi, a former BOJ board member, estimates that even accounting for the U.S.-Japan trade agreement, U.S. tariffs will still reduce Japan's annual GDP growth by 0.55 percentage points.

"Economic fundamentals are not strong, consumption is flat, and the export outlook remains dim," the third source said.

While Uchida praised the trade agreement for reducing uncertainty, he also cautioned that the impact of U.S. tariffs on corporate confidence and spending plans remains unclear.

Critical will be the BOJ's next "tankan" business survey in October and the regional branch managers' quarterly meeting the same month – when the BOJ will gain a deeper understanding of how businesses across the country are coping with the impact of tariffs.

These results will be released before the BOJ's policy meeting on October 29-30. For now, market focus will turn to Kazuo Ueda – who will hold a news conference on July 31 at the end of the two-day rate review.

"The outlook report and governor's press conference may send a signal that the BOJ is gradually approaching another rate hike, albeit cautiously," said Ryutaro Kono, chief Japan economist at BNP Paribas.