WRAPUP 1-BOJ keeps rates steady, delivers hawkish signal as government props up yen

The Bank of Japan warned that underlying inflation could exceed its 2% target, prompting concerns of further rate hikes due to rising inflation expectations and global economic pressures.

The Bank of Japan kept interest rates steady on Friday but warned for the first time that underlying inflation could exceed its target, signalling further rate hikes in the wake of the government's yen-buying intervention. The central bank also highlighted inflationary pressures from robust global AI-demand and said concern over the economic hit from the Middle East conflict was receding, underscoring its focus on inflation risks ‌that could warrant higher rates.

"There is a risk underlying inflation could deviate above our 2% target as medium- and long-term inflation expectations continue to rise, and firms become more active toward raising prices and wages," the BOJ said in a quarterly outlook report. "We must pay due attention to keep such a risk from materialising and exert an adverse impact on the economy."

That language was stronger than that used in the previous outlook report released in April, in which the BOJ said underlying inflation was approaching 2% and required the central bank to be ‌vigilant to upside price risks. At the two-day policy meeting that ended on Friday, the BOJ kept short-term interest rates steady at 1% in a widely expected move after a hike to the 31-year-high level just last month.

Board member Hajime Takata was the ‌sole dissenter to the decision, calling for a rate hike to 1.25% to respond to inflationary risks from external demand shocks. The BOJ's decision and its hawkish statement pushed up the two-year Japanese government bond yield but did little to prop up the yen, which hovered around 160.760 per dollar.

"The BOJ's outlook report was hawkish and we're sticking to our non-consensus view that the central bank will lift interest rates to 2% by the end of next year," said Marcel Thieliant, head of Asia-Pacific at Capital Economics in Singapore. "The decision itself wasn't unanimous because arch hawk Hajime Takata once again dissented in favour of a rate hike just as he did in ⁠April. That's remarkable ​given that the bank just raised rates at its June meeting."

YEN PRESSURES The ⁠BOJ's decision came after Japan conducted yen-buying, dollar-selling market intervention in New York markets on Thursday, a move that failed to give the yen a sustained boost.

In a sign Tokyo's action had the blessing of Washington, U.S. Treasury Secretary Scott Bessent said Japan may have intervened to prop up its currency that looked "very undervalued," according to ⁠a Fox Business Network reporter. The government's action and comments by Bessent, who has repeatedly urged the BOJ to raise rates, put the market's focus on how hawkish Governor Kazuo Ueda could be on the future rate path in his post-meeting news briefing.

The BOJ maintained its pledge to keep raising interest rates. ​Developments in the Middle East, expansion in AI-related demand and exchange-rate developments will be among factors the BOJ will look at in considering the timing and pace of future rate hikes, it added. The BOJ meeting follows the U.S. Federal Reserve's ⁠on Wednesday, which kept rates steady, although three dissenters called for a quarter-percentage-point hike.

The BOJ raised rates to a 31-year high in June and signaled its readiness to tighten further as it focuses on taming price pressures from the energy shock. Most analysts polled by Reuters expect the BOJ to raise rates again to 1.25% by year-end. The slow ⁠pace ​of rate hikes has been blamed for pushing the yen to a 40-year low, leading to rising import costs that hurt households and retailers.

Japan's yen-buying intervention, first reported by the Nikkei newspaper, would be the first since Tokyo's record $73 billion yen-buying spree between late April and early May that had little effect in reversing the currency's downtrend. Tokyo's top currency diplomat Atsushi Mimura on Friday declined to comment on intervention but hinted at U.S. involvement in the effort to stem the yen's decline, including so-called rate checks by the Fed.

He said ⁠Japan was communicating closely with South Korea, which also conducted dollar-selling intervention on Thursday. HAWKISH URGES

Analysts say BOJ chief Ueda may need to talk down yen bears through hawkish communication, as prospects of U.S. rate hikes weigh on the yen's value against the dollar. But ⁠pressure from a dovish administration and the potential economic hit from a ⁠7.1-magnitude earthquake this week in the southern prefecture of Kumamoto, home to plants of major manufacturers and chipmakers, may dampen the hawkish mood.

So far, the economy appears to have weathered the hit from rising fuel costs and supply disruptions from the Middle East conflict, which are driving up inflation. Factory output rose in June and manufacturers projected further increases this month and next, data showed on Friday.

Separate data ‌also showed annual core inflation in Japan's capital ‌accelerated to 1.7% in July, a sign of broadening price pressures from the Middle East conflict.