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G3: Policy divergence between the Fed and BOJ/ECB. Markets expect policy divergence between the Fed and ECB/BOJ in September. With a series of muted data prints from the US over the past few weeks, investors are paring Fed hike expectations. By contrast, pricing for further tightening by the BOJ and ECB has firmed up. The odds of BOJ’s September hike are now hovering close to 80%. Similarly, the market is assigning 90% odds of an ECB hike in September. It is interesting that inflation breakevens are higher now compared to three months ago for Japan and Germany (in contrast to the US). This could be a factor explaining why the ECB and BOJ are keeping to a tightening stance despite the fall off in oil prices.
For Japan, we revised our 2026 and 2027 GDP growth forecasts to 0.9% and 1.0%, respectively, from 0.5% and 0.5% previously. Our CPI inflation forecast is maintained at 1.8% for 2026 but revised down to 1.5% for 2027. The 2Q26 GDP data released on 17 August, while lower than consensus, was in line with our expectations at 1.1% q/q saar. The 1.1% growth followed a strong 1.9% expansion in 1Q26 and remained broadly in line with Japan’s average growth rate over the past five years. Our annual forecast revisions, to a large extent, take into account the government’s recent approval to cut the food consumption tax from 8% to 1%, effective from April 2027. Food has a large weight in Japan’s CPI, and reducing the tax rate on food products to 1% is estimated to lower 2027 CPI inflation by a significant 1% pts. Given that food is a daily necessity and a substantial portion of the tax savings is likely to be saved, we estimate that the boost to 2027 GDP growth will be modest, at around 0.2% pts.
We expect the BOJ to accelerate the pace of rate hikes to 25bps every 3-4 months, from once every 6 months previously, with a higher terminal rate of 1.75% in the current tightening cycle. We bring forward our expected timing of the next BOJ rate hike to September and expect two further moves in 1Q27 and 2Q27, respectively, taking the overnight call rate to 1.75% by mid-2027. The latest BOJ communication has become more hawkish, while the government also appears less opposed to an early hike, further increasing the likelihood of a September move. Various measures suggest that underlying inflation has reached a stable 1.5-2.0% range (CPI excluding fresh food, energy, and institutional factors: 2.0%; trimmed-mean CPI: 1.6%), pointing to a neutral interest rate of around 2%.
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