Bank of Japan set to keep rates unchanged amid political instability, US-Japan trade deal

• The Bank of Japan is expected to hold interest rates at 0.5% for the fourth consecutive meeting on Thursday.
• Markets will closely scrutinize the BoJ policy statement and the updated projections for hints on the timing of the next rate hike.
• The BoJ policy announcements are set to inject intense volatility around the Japanese Yen.

The Bank of Japan (BoJ) is set to hold the short-term interest rate at 0.5% following the conclusion of its two-day July monetary policy review on Thursday.

Amid the US-Japan trade deal optimism and uncertainty of the US tariff impact on the Japanese economy, markets will closely scrutinize the BoJ's Monetary Policy Statement and the updated forecasts in its Quarterly Outlook Report for fresh signals on when the bank could resume its rate-hiking cycle.

The Japanese Yen (JPY) remains primed for a big reaction following the BoJ policy announcements.

What to expect from the BoJ interest rate decision?

The BoJ is widely expected to keep the policy rate at the highest level in 17 years for the fourth consecutive meeting in July.

The Japanese central bank is expected to revise up its inflation forecast for the current fiscal year, considering the persistent rises in rice and broader food costs, as Reuters reported on July 14, citing three sources familiar with the BoJ's thinking.

Since then, Japanese Prime Minister Shigeru Ishiba's ruling coalition faced a bruising defeat in upper house elections on July 20, and US President Donald Trump announced a trade deal with Japan on July 22.  

Despite increased inflation expectations, amid political instability-led potential for a weak Japanese Yen and Trump's 15% tariffs-driven impact, the BoJ will likely stick to its wait-and-see stance in July.

The central bank would want to assess the impact of higher US tariffs on corporate wage growth and domestic consumption before adjusting its policy.

Meanwhile, the latest government data released on Friday showed that the Tokyo Consumer Price Index (CPI), which excludes volatile fresh food costs, rose 2.9% in July from a year earlier, slightly below the market forecast for a 3.0% increase. It followed a 3.1% rise in June.

Food inflation, excluding the cost of volatile fresh products, accelerated to 7.4% in July from 7.2% in June, per Reuters.

Even though core inflation in Japan's capital slowed in July, it stayed well above the central bank's 2% target, refuelling market expectations for another interest rate hike this year.

How could the Bank of Japan's monetary policy decision affect USD/JPY?

BoJ Deputy Governor Shinichi Uchida delivered a cautious outlook on Japan's economy during a speech on July 23, warning of sustained downside risks to growth and inflation outlook due to "extremely high" global trade uncertainty. 

His comments came after board member Junko Koeda recently argued for the need to monitor the second-round effects of rising rice costs.

Meanwhile, hawkish BoJ policymakers Hajime Takata and Naoki Tamura continued to advocate for the bank to resume rate hikes after a temporary pause.

Therefore, the language in the BoJ's policy statement and Governor Kazuo Ueda's words during the presser will hold the key to gauging the bank's path forward on interest rates.

If the BoJ sticks to its data-dependent stance for a policy move, dismissing easing trade tensions and hopes of another rate hike this year, the JPY could see a fresh leg lower against the US Dollar (USD).

However, the odds of a rate hike by year-end could ramp up if the BoJ expresses concerns over elevated food costs alongside upside risks to inflation amid the US tariff impact. Such a scenario could fuel a fresh recovery rally in the Japanese Yen and a downtrend in the USD/JPY pair.

Any big reaction to the BoJ policy announcements could be short-lived as markets would await Governor Ueda's press conference for fresh policy insights.

From a technical perspective, Dhwani Mehta, Asian Session Lead Analyst at FXStreet, notes: "Despite the latest pullback from the weekly high of 148.81, the USD/JPY pair retains its bullish potential, with the 14-day Relative Strength Index (RSI) still holding above the midline."

"The pair could accelerate its corrective decline on a hawkish BoJ hold, with the immediate support seen at the 21-day Simple Moving Average (SMA) at 147.04.  Failure to resist above that level will open up further downside toward the 146.00 round number. The next healthy support aligns at the 100-day SMA of 145.70. Alternatively, buyers must scale the weekly high to resume the uptrend toward the July 16 high of 149.19. Further up, the 200-day SMA at 149.58 will test bearish commitments," Dhwani adds.