By Leika Kihara and Takahiko Wada
TOKYO, July 30 (Reuters) - The Bank of Japan may shift to an inflation fighting posture from inflation tolerance as soon as December, which would mean an acceleration in rate hikes, said Tsutomu Watanabe, a former central bank official known as an expert on price trends.
Japan is experiencing a third wave of inflation caused by the Middle East conflict, following the first wave triggered by the Ukraine war, and a second one driven by domestic wage hikes and rising
rice costs, he said.
The third wave will likely be more modest than the past two with consumer inflation excluding fresh food and fuel peaking near 3% around March next year, before slowing towards the BOJ's 2% target, Watanabe, emeritus economics professor at the University of Tokyo, said in an interview on Wednesday.
"But the real concern is underlying inflation, which is unmistakably rising and now quite close to 2%," as a tight labour market and a flurry of price rises lift wage growth and inflation expectations, he said.
Such mounting price pressures require a revamp in Governor Kazuo Ueda's approach of taking rate hikes slowly and tolerating price rises to ensure the once deflation-prone economy durably hits 2% inflation, Watanabe said.
"When underlying inflation was well below 2%, the BOJ's focus was to 'nurture' price pressures that helped prop up inflation. That's no longer the case," he said.
Watanabe said his estimates from price data suggested that underlying inflation could overshoot to 2.2% around July next year if the BOJ maintains the current slow pace of rate hikes.
"That would be pretty problematic and could force the BOJ to rush into raising rates aggressively later, something it definitely wants to avoid," Watanabe said.
"The BOJ is probably well aware of the need to shift away from its 'passive' approach tolerant of price rises, to an 'active' one focusing on combating inflation," said Watanabe, who retains close contact with incumbent policymakers.
Key to the timing of such a shift will be next year's wage outlook, as uncertainty over the Middle East conflict may prod some firms to hold off on offering pay increases, he said.
If comments from labour unions and business lobbies suggest that next year's wage gains will roughly match the solid growth seen in the past few years, the BOJ will shift to an "inflation fighter" mode as soon as December, Watanabe said.
Under the new regime, the BOJ will likely raise rates at a pace of once every quarter rather than the current speed of roughly twice a year, Watanabe said.
NEW CHALLENGE
After decades seeking to beat deflation with ultra-easy monetary policy, the BOJ exited massive stimulus in 2024 as external supply shocks such as the Ukraine war, coupled with rising wages from a tight job market, lifted inflation above 2%.
The BOJ also raised interest rates several times including in June, though its policy rate, at 1%, keeps real borrowing costs negative with consumer inflation hovering around 2%.
Watanabe, who has written numerous books on Japan's price trends, warned the country's battle with inflation could be more challenging than other countries.
Preoccupied with a prolonged battle with deflation, the BOJ lacks experience combating inflation which, coupled with the slow pace of rate hikes so far, led to market doubts over its inflation-fighting credentials, he said.
"Markets are questioning whether the BOJ really has the resolve and ability to curb inflation at around 2%. It needs to send a clear message that it will set monetary policy under different rules," Watanabe said.
"The BOJ succeeded in de-anchoring inflation from zero. But the challenge to re-anchor inflation to 2% has only just begun."
(Reporting by Leika Kihara and Takahiko Wada; Editing by Sam Holmes)
