A dovish shift by the Fed could provide some respite to the Bank of Japan in its battle to curb yen weakness, but its efforts to raise rates could become more complicated if the divergence in the two central banks’ policy paths unsettles markets.

Fed Chairman Jerome Powell gave his strongest signal yet on a rate cut at an annual economic symposium in Jackson Hole, Wyoming, saying the time had come for a policy change as risks to the job market were rising and there was no room for further weakness.

The comments came hours after Bank of Japan Governor Kazuo Ueda told parliament that the central bank would closely monitor the impact of market instability but would continue to raise interest rates if inflation remained on track to hit its 2 percent target.

The yen rose against the dollar after Ueda's speech and extended gains on Powell's comments as markets focused on the prospect of a narrowing gap in U.S. and Japanese interest rates. The yen's rapid appreciation has triggered a wave of unwinding of popular carry trades, sending global financial markets into turmoil.

Derek Halpenny, head of global market research at MUFG, said in a note to clients that Ueda had shown little sign of changing his views and plans after the financial market turmoil earlier this month, so the yen buying was understandable.

The yen's rebound came as a relief to the Bank of Japan, which has been under political pressure from politicians to stop the yen from weakening as higher costs for imported food and fuel hurt consumption.

As Japan goes against the tide of global interest rate cuts, the yen and Japanese stocks face the risk of sharp fluctuations, which makes the Bank of Japan's path to raising interest rates full of uncertainty.

The Bank of Japan has felt the need to tread carefully after markets swung wildly following its July rate hike. "Both domestic and foreign markets remain unstable, so we will remain highly vigilant to market developments for now," Ueda said on Friday.

Domestic politics also complicate the BOJ’s path to rate hikes as Prime Minister Fumio Kishida, who appointed Ueda as BOJ governor, is due to step down in September and pass the baton to the winner of the ruling party leadership race.

While most of the leading candidates to succeed Kishida back the BOJ’s plans for modest rate hikes, it is unclear whether the new prime minister would back a hike if volatile markets weigh on corporate profits.

“The BOJ may not be able to take bold steps because there are so many uncertainties,” said Makoto Sakurai, a former BOJ board member. “It may be difficult for the BOJ to raise interest rates until the domestic political situation stabilizes,” he said.

Most economists expect the Bank of Japan to raise interest rates again this year, but more believe the hike is more likely to happen in December rather than October, a new Reuters poll showed.

The BOJ unexpectedly raised interest rates in July and Ueda signaled further rate hikes earlier this month, shocking financial markets and forcing his deputy to offer dovish assurances that there would be no rate hikes until markets stabilized.

Two sources familiar with the BOJ’s thinking said the key message from Ueda’s speech to parliament on Friday was that while the BOJ would not rush to raise rates, the market rout would not derail its long-term plans to continue pushing up borrowing costs.

Jeffrey Young, CEO of DeepMacro, a U.S. fintech company that uses artificial intelligence to analyze economic indicators and policymakers' remarks, said a big data analysis of the Bank of Japan's recent comments showed that its rate hike stance remained "very aggressive."

“One more rate hike before the end of the year? Very likely. I think that’s what the model says,” he said of the possibility of another rate hike by the Bank of Japan. “If inflation and growth are both on the firm side, and the Bank of Japan’s rhetoric is still biased towards saying that inflation and growth are fine, then the only thing that can really stop it from raising rates is market turmoil.”

However, some analysts are more cautious about the strength of the Japanese economy. While consumption rebounded in the second quarter, rising living costs have weighed on household confidence. A slowing U.S. economy could also weigh on exports.

“Domestic demand is very weak,” said Sayuri Shirai, a scholar at Keio University in Tokyo. “From an economic perspective, there is little reason for the Bank of Japan to raise rates.”

Article forwarded from: Jinshi Data