Japan: The Difficult Balance Between Monetary and Fiscal Policies Will Continue

■ The Bank of Japan is expected to raise interest rates at its June meeting and halt the reduction in its government bond purchases, demonstrating its policy intention to curb the rise in long-term interest rates.  

■ If consumption tax cuts, growth investment, and energy subsidies continue, market concerns about fiscal deterioration may be exacerbated again. 
 
The Bank of Japan's monetary policy meeting, held on the 15th and 16th, is expected to raise the policy rate from 0.75% to 1.00%. Recent data shows that the Japanese economy remains resilient, but inflationary pressures are increasing. Currently, the Bank of Japan's policy rate level remains relatively loose. If it continues to wait and see due to uncertainties in the Middle East, it may lead to a delayed policy response and increase the risk of having to raise interest rates significantly in the future. Therefore, the Bank of Japan is likely to deem it necessary to implement an interest rate hike at this meeting. In addition, the meeting is expected to decide to stop reducing the scale of government bond purchases from April 2027. According to the announced reduction plan, the Bank of Japan's government bond purchases will begin at approximately 2.7 trillion yen in the April-June 2026 quarter, decreasing by 200 billion yen each quarter, until reaching approximately 2.1 trillion yen in the January-March 2027 quarter. The tapering plan will then come to an end, and the monthly purchase scale of approximately 2.1 trillion yen will be maintained after April 2027. 

 
Affected by inflation concerns stemming from rising oil prices and market wariness of fiscal expansion, the yield on Japanese 10-year government bonds climbed rapidly in mid-May, reaching 2.8% at one point, a new high since 1996. It is expected that the Bank of Japan will not only raise interest rates at its June meeting but also signal the possibility of further rate hikes in the future. At the same time, by halting the tapering of government bond purchases—a move leaning towards easing—it is signaling to the market its intention to curb the rapid rise in long-term interest rates. 

 
On the fiscal front, a supplementary budget of 3.1 trillion yen was formally approved on the 5th. The largest expenditure item is a 2.5 trillion yen "reserve fund for dealing with the situation in the Middle East," which is expected to be mainly used for gasoline subsidies. Since its launch in late March, gasoline subsidies have continuously pushed up government spending due to persistently high international oil prices. The original funds are said to be exhausted around this summer, and this increase in the reserve fund is precisely to fill this gap. According to data released by the Ministry of Finance, gasoline subsidy expenditures in April totaled 310 billion yen. If this level is maintained monthly, the newly added reserve funds will be almost entirely used for gasoline subsidies this fiscal year. 

 
Since this supplementary budget avoided issuing additional deficit bonds, excessive market concerns about a deteriorating fiscal situation eased in May, and the rapid rise in government bond yields gradually stabilized. However, if gasoline subsidy expenditures further increase, or if the government needs to introduce other support measures such as electricity and gas subsidies, further supplementary budgets may still be necessary in the future. Furthermore, the government is currently studying policies such as implementing a food consumption tax reduction starting in the next fiscal year and arranging a large-scale growth investment budget; therefore, the risk that fiscal issues will again become a market focus in the second half of this year remains. At the same time, the government is also discussing reducing its long-standing and massive energy subsidy expenditures, and the direction of related policies deserves continued attention. Against the backdrop of continued instability in the Middle East, the Japanese government and the Bank of Japan will continue to face difficult policy choices and balances.