Is interest rate hike imminent? The Bank of Japan is urged to abandon vague inflation indicators and establish a clear interest rate hike path

Internal disagreements have emerged within the Bank of Japan regarding its monetary policy communication strategy, with some board members calling for the abandonment of the vague "potential inflation" indicator in favor of more hawkish policy statements. This change could pave the way for an interest rate hike in October this year.

On Wednesday, August 13, media reports indicated that there is an increasing number of voices within the Bank of Japan calling for the abandonment of the vague measurement of "potential inflation."

The so-called "potential inflation" mainly reflects the growth of domestic demand and wages, and is viewed by the central bank as a reference for the pace of interest rate hikes. Bank of Japan Governor Kazuo Ueda has consistently argued for gradual rate increases, citing that "potential inflation" is below the central bank's 2% target. However, this concept lacks a unified and clear statistical method, leading to criticism that the Bank of Japan overly relies on a vague indicator to formulate policy, especially in the context of inflation exceeding the 2% target for more than three consecutive years.

Data shows that Japan's annual core consumer price index reached 3.3% in June, exceeding the central bank's 2% target for more than three consecutive years, primarily driven by an 8.2% surge in food costs. This price pressure prompted the Bank of Japan to raise its core inflation expectations last month, also leading the market to question the central bank's assertion that "potential inflation" has not yet reached 2%.

Inflation Pressure Continues to Rise, Internal Disagreements Emerge

Now, some policy committee members within the Bank of Japan are concerned that a "second-round inflation effect" is forming, meaning that inflation effects may become entrenched in corporate pricing behavior and public expectations for future inflation. They are calling for a shift in policy communication focus towards more intuitive overall inflation.

According to the summary of opinions from the Bank of Japan's July monetary policy meeting, some members stated that communication should shift from "potential inflation" to actual price trends and their outlook, output gaps, and inflation expectations. Another member argued that the central bank must pay more attention to the risks of rising inflation and adjust its communication strategy to emphasize that "Japan will achieve 2% inflation."

Among the nine board members of the central bank, Naoki Tamura, Soichiro Takada, and Junko Oda all emphasized that the continued rise in food prices could trigger broader and more persistent inflation risks, but there has yet to be a consensus within the board on whether to adjust the communication strategy.

Not only are there disagreements within the central bank, but some members of Japan's highest economic advisory body have also publicly warned that the Bank of Japan may be overly complacent about the escalating price pressures. This is seen by the market as a clear signal urging the central bank towards a more hawkish policy.

A member of the advisory body stated at last week's meeting that monetary policy has fallen behind the situation, and the ongoing price increases are already affecting people's lives and their expectations for inflation.

Economic Expectations Improve, October May Be a Key Window for Rate Hike

The Bank of Japan ended its decade-long ultra-loose stimulus program last year and raised short-term interest rates to 0.5% in January this year. However, due to the impact of U.S. tariff increases on the economy, the central bank downgraded its economic growth expectations in May, complicating the timing of the next rate hike. Nevertheless, with Japan reaching a trade agreement with the United States in July, the central bank's pessimistic view of the economic outlook has eased Some committee members have publicly called for adjustments to the dovish communication approach, highlighting the council's increasing concern over the spread of inflationary pressures. This change may pave the way for interest rate hikes in the coming months and even into 2026.

Senior Bank of Japan observer Naomi Muguruma stated that the central bank may gradually eliminate the concept of "potential inflation" from its communications in preparation for the next interest rate hike, which could occur as early as October. She remarked:

"I think many central bank officials are beginning to realize that this concept does not align well with reality. As the timing for the next interest rate hike approaches, we may hear less about this concept."