Why neutral rate estimates suggest BoJ hikes to 1.5%
We’ve raised our terminal rate assumption for the Bank of Japan to 1.5% from 1% in February. This reflects changes in our estimate for Japan’s neutral interest rate, r* – the equilibrium level at which the policy rate should eventually settle – resulting from recent revisions to GDP, a new fiscal policy outlook, and rising inflation expectations.
Stripping out inflation expectations, we find that the real neutral rate in 2020-2025 has risen by 0.1ppts-0.2ppts, largely due to higher productivity gains implied by the recent GDP revisions.
Our structural model predicts the real neutral rate will rise gradually until 2030, driven by moderate gains in productivity growth, quantitative tightening by the BoJ, and – to a lesser extent – rising government debt. Adverse demographics will continue to limit the gain, however.
On top of that, higher inflation expectations are contributing to a higher neutral rate in nominal terms. We think inflation expectations will stay high, shaped by persistent inflation outturns and structural labour shortages that are driving wage-cost pass-through.
We now expect the BoJ to chase the nominal neutral rate up to 1.5% by 2027. We anticipate the BoJ hiking three times: in June and December 2026, and June 2027.
