• The Bank of Japan (BOJ) is divided over the pace of future interest rate hikes.
• Two members argue for a "timely and gradual" increase to prevent rapid future hikes.
• Others warn against swift policy normalization, citing unanchored inflation expectations.
• BOJ Governor Kazuo Ueda faces the challenge of pushing rates to a neutral level amidst economic uncertainties.

The Bank of Japan (BOJ) finds itself in the midst of a heated debate, as revealed in the minutes of their July meeting. The central issue is the pace at which the central bank should raise interest rates further. This disagreement underscores the uncertainty surrounding the timing of the next increase in borrowing costs.

In an unexpected move during the July meeting, the BOJ raised short-term interest rates to 0.25% by a 7-2 vote. This decision marked another step towards phasing out a decade of massive stimulus that has characterized Japan's monetary policy. However, the decision was not unanimous, reflecting differing views within the nine-member board.

Two members of the board saw room for further rate hikes. One of them argued that the BOJ should increase borrowing costs in a timely and gradual manner. This approach, they argued, would prevent the bank from being forced to raise rates rapidly in the future.

BOJ's Approach to Rate Hikes

Another member echoed this sentiment, stating that the BOJ must raise rates further once it was confirmed that firms were increasing capital expenditure, wages, and prices. This view suggests a data-dependent approach, where policy decisions are guided by economic indicators.

However, not all members were in favor of swift policy normalization. Several warned against proceeding too quickly in phasing out stimulus. One member was quoted as saying, Normalization of monetary policy must not be an end in itself. This statement underscores the need for the BOJ to monitor various risks and move carefully.

Another member expressed concern about market expectations for future rate hikes increasing excessively. They pointed out that inflation expectations have yet to be anchored at the BOJ's 2% target, and prices remained vulnerable to downside risks.

Challenges for BOJ Governor Kazuo Ueda

The BOJ Governor, Kazuo Ueda, faces a significant challenge in meeting his pledge to eventually push up interest rates to a neutral level - a level that neither stimulates nor cools growth. One member pointed out the difficulty of automatically pushing up interest rates to a set level given the high uncertainties in estimating Japan's neutral rate.

The BOJ's rate hike in July and Ueda's hawkish comments, coupled with weak U.S. labor market data, triggered a spike in the yen and a stock market rout in early August. Since then, BOJ policymakers have emphasized the need to consider the economic fallout from market volatility.

After the BOJ's decision to keep rates steady in September, Ueda reiterated that the bank would increase borrowing costs if inflation makes progress in durably hitting its 2% target. The governor also indicated that the BOJ could afford to spend time assessing how U.S. economic uncertainties affect Japan's fragile recovery, signaling that the bank was in no rush to hike rates further.

Japan's core consumer inflation hit 2.8% in August and has been at or above the BOJ's 2% target for 29 consecutive months. This trend suggests that the BOJ's monetary policy has been effective in stimulating inflation. However, it also raises questions about the sustainability of this trend and the potential risks of overheating.

Japan's economy expanded at an annualized rate of 2.9% in the second quarter, buoyed by steady wage hikes that underpinned consumer spending. Capital expenditure continues to grow, indicating a healthy domestic economy. However, soft demand in China and slowing U.S. growth cloud the outlook for the export-reliant country.

The BOJ's current predicament is reminiscent of the late 1980s when Japan faced a similar dilemma. Then, as now, the central bank was grappling with the challenge of managing economic growth while keeping inflation in check. The BOJ's decision to raise interest rates in 1989 is widely believed to have triggered the burst of the asset price bubble, leading to a prolonged period of economic stagnation known as the Lost Decade.