The Organization for Economic Co-operation and Development (OECD) forecasts that the Bank of Japan will raise its short-term policy interest rate from 0.75% to 2% by the end of 2027 to counter rapid price increases driven by the Middle East conflict.
The OECD believes that the Japanese economy is transitioning from nearly three decades of zero inflation to a phase of rising prices and wages, supported by domestic demand, and urges the Japanese government to increase consumption tax to boost fiscal revenue.
On Wednesday, the Organisation for Economic Co-operation and Development (OECD) released a report forecasting that the Bank of Japan is expected to raise its short-term policy interest rate from the current 0.75% to 2% by the end of 2027. This assessment supports the hawkish stance adopted by the Bank of Japan ahead of its June policy meeting.
Under external shocks stemming from the Middle East conflict, domestic prices in Japan are rapidly increasing, necessitating an urgent interest rate hike by the Bank of Japan to mitigate these external pressures.
Inflation within Japan is accelerating.
As Japan gradually moves away from nearly zero inflation over recent decades, inflation expectations domestically are rising significantly, with robust wage growth further supporting the case for continued interest rate hikes.
The OECD urges the Japanese government to rely on raising the consumption tax to increase fiscal revenue, as the current rate of 10% remains the lowest among member countries.
The OECD also reported that Japan's initial rise in inflation reflected external factors, such as commodity price increases triggered by the outbreak of the Iran war; however, internal pressures have since been mounting as labor shortages have led to nominal wage increases.
The Japanese economy is currently in a transitional phase, moving from nearly three decades of zero inflation toward an economy characterized by rising prices and wages, underpinned by domestic demand.
While uncertainties caused by external adverse factors require cautious handling, interest rates should continue to be raised due to rising inflation expectations, robust nominal wage growth, and a narrowing output gap.
Pressure on the Bank of Japan to raise interest rates is increasing.
The OECD forecasts that Japan's economy will grow by 0.7% year-on-year in 2026 and 0.9% in 2027, slowing from last year's growth rate of 1.2%.
The report states that with robust domestic demand supporting economic growth, Japan's inflation rate is expected to move closer to the Bank of Japan's target of 2% during the 2026-2027 period.
In the most recent two monetary policy meetings, although the Bank of Japan has maintained its current stance, there has been a growing internal push for interest rate hikes. Several officials have expressed concerns about inflationary pressures, and this series of hawkish signals increases the likelihood of action at its next meeting on June 15-16.
The OECD predicts that by the end of 2027, the Bank of Japan’s policy interest rate will reach 2%, and it welcomes the central bank's gradual reduction in purchases of Japanese Government Bonds (JGBs), part of efforts to wean Japan's economy off large-scale stimulus measures.
However, the OECD noted that risks remain in Japan's government bond market. Some analysts also attribute the slowdown in the Bank of Japan's bond-buying pace to increased volatility in the Japanese government bond market.
At the June policy meeting, the Bank of Japan will review its bond tapering plan through March next year and formulate a new fiscal year bond purchase plan starting from April next year.
Editor/melody