By Megumi Fujikawa


TOKYO--The Bank of Japan faces a critical test next week, when it will chart the course for monetary policy in a volatile environment of surging energy prices, persistent yen weakness and building political pressure.

Given recent messaging from BOJ official--including Gov. Kazuo Ueda--markets widely expect the central bank to hike interest rates to a 31-year high to counter the price shock stemming from the Middle East conflict. While the inflationary case for tightening is clear, the decision carries the risk of slowing economic growth and curbing investment just as Japan's economic recovery was taking shape.


The Hike: At the conclusion of its two-day meeting on Tuesday, the Japanese central bank is expected to raise its policy rate to 1%, the highest level since 1995. That would mark its first hike since last December.

Markets have almost fully priced in the resumption of tightening, reflecting policymakers' growing concern about an acceleration in underlying inflation since the BOJ last met in late April.


Why Now: Policymakers don't necessarily believe that a 25-basis-point hike by itself can quell inflationary forces caused by a war-induced oil shock, according to people familiar with the bank's thinking. However, they do expect the move to ease strain on the yen, the weakness of which has inflated import costs and increased the burden on corporate and consumer budgets, the people said.

The policy board also sees a need to adjust the real interest rate--a measure adjusted for inflation which remains deeply negative and far lower than the neutral level that is neither restrictive nor stimulative to the economy, the people said. Policymakers are worried that if inflation speeds up more than expected, the bank may be forced to raise interest rates sharply later on, the people added.


Market Trust: Some officials are also growing wary of the alarm bells sounding in government bond markets, where yields are rising rapidly. In addition to fears about inflation and worsening fiscal conditions, some investors have started doubting the BOJ's independence.

Those doubts reflect the view that Prime Minister Sanae Takaichi, who is seen as favoring loose monetary policy, might lean on the BOJ to keep rates steady as part of efforts to boost domestic investment.

BOJ Gov. Ueda has recently said it is important to secure the market's trust in the bank's ability to address inflation when needed. Otherwise, government bond yields could climb even higher.


Ueda's Absence: Another curveball for already-jittery markets came when the BOJ said Ueda had been hospitalized and would miss next week's meeting. However, his absence is unlikely to change the rate decision as the board appears to share his concern over rising costs.

Deputy Gov. Shinichi Uchida, who will hold the post-meeting news conference on Tuesday usually handled by Ueda, is unlikely to present views that contrast sharply with the governor's stance, said Yusuke Matsuo, an economist at Mizuho Securities, noting that the BOJ chief and his deputies move in lockstep. "The overall tone of the bank's communication is expected to remain largely unchanged," he said.


Write to Megumi Fujikawa at megumi.fujikawa@wsj.com


(END) Dow Jones Newswires

06-12-26 0536ET