Between fiscal stimulus and monetary tightening, Japan is walking on a tightrope

The prospect of a new fiscal stimulus plan has reignited pressure on long-term rates and weakened the yen. Against a backdrop of already high inflation, the new prime minister's desire to revive the economy is complicating the Bank of Japan's task.

It is not just the geopolitical situation that is becoming tense for Japan. Against a backdrop of rising tensions with China, investors are also concerned about the fiscal situation.

In recent hours, long-term rates have risen—the 40-year rate reached its highest level since 2007—following statements by Finance Minister Satsuki Katayama, who said that the next fiscal stimulus plan had already been "somewhat expanded."

And, according to Bloomberg, lawmakers from the ruling LDP party are pushing for more spending. They are calling for an additional 25 trillion yen ($161bn).

The election of Sanae Takaichi as head of the LDP in early October had already contributed to pressure on long-term rates. The new prime minister is seen as the heir to Shinzo Abe, a proponent of fiscal and monetary stimulus.

If parliamentarians are pushing for more spending, it is to address Japanese discontent with what is considered high inflation. But a fiscal stimulus policy (which stimulates activity) is more likely to push prices up. Ultimately, this could give the Bank of Japan additional ammunition and lead to further rate hikes.

All eyes on the BoJ

Prime Minister Takaichi met with Governor Ueda today. The latter indicated that she had not made any requests regarding monetary policy.

This statement somewhat allays fears of government pressure on the BoJ. However, it is difficult to imagine a central banker saying anything else, so as not to undermine his independence and credibility.

Since 2024, the Bank of Japan has been on a path of rate hikes. This is a normalization of its monetary policy after years of negative rates and with inflation above 2% for more than three years.

After several rate hikes, the Bank of Japan has left its key policy rate unchanged at 0.5% since January.

At the last meeting in late October, Governor Ueda hinted that a rate hike in December was possible, indicating that the probability of his baseline scenario materializing had increased.

However, third-quarter growth figures are likely to encourage the Bank of Japan to exercise caution. The Japanese economy contracted by 1.8% year-on-year, mainly as a result of a decline in exports to the United States.