The strong wage settlement amid labor shortages will boost real wages and underpin underlying price pressures, supporting the case for further hikes.  But Japan’s room for aggressive tightening is limited.  The economy lacks clear drivers of growth, and inflation expectations are not anchored at the 2% target.  Actual inflation is likely to drop back below 2% by the end of next year.  This was the reason the BoJ stressed that monetary policy will continue to remain easy for the time being, and that the bank will continue to purchase JGBs. 

Higher interest rates would make it harder for the government to finance the country’s massive debt, which is twice the size of its economy and the largest among developed nations.  Businesses could also be shocked by higher borrowing costs.  Narrowing interest rate differentials will lead to a stronger yen, which will counteract inflation and lower export earnings. 

Japan has exited a prolonged period of deflation and its workers secured strong pay increases, but the virtuous cycle between wages and prices won’t become permanent until the economy addresses its long-term structural challenges.  The era of negative interest rates in Japan has ended, but the march towards a neutral policy stance is ongoing.