Shadow of Abenomics clouds BOJ's rate hike path

By Leika Kihara

TOKYO (Reuters) - Political uncertainty and the surprise prominence of a reflationist-minded candidate in Japan's ruling party leadership race may add pressure on the central bank to go slow on raising interest rates further away from historic lows.

Already, the Bank of Japan (BOJ) has toned down some of its signaling around future rate hikes as U.S. recession risks and jittery financial markets cloud the economic outlook.

Now, a fresh complication comes from politics as Friday's race to choose the ruling Liberal Democratic Party's (LDP) new leader, who in turn becomes next prime minister, heats up.

Sanae Takaichi, a 63-year-old advocate of deceased former premier Shinzo Abe's "Abenomics" stimulus policies, is emerging as among three of the nine candidates likely to make it to the run-off.

The once dark-horse candidate, who could become Japan's first female leader, is a sole but vocal opponent of further interest rate hikes.

"What we're seeing now is cost-push inflation. We must keep monetary policy accommodative until real wages stably turn positive," Takaichi told reporters on Sept. 19.

"I think it would be stupid to raise interest rates now," she said in an interview streamed online on Monday, warning that doing so could push Japan back into deflation.

Opinion polls show Takaichi and two other candidates, former defence minister Shigeru Ishiba and former environment minister Shinjiro Koizumi, as frontrunners.

Some analysts see Ishiba and Koizumi as having an edge over Takaichi, though the polls show the race is too close to call.

"If Takaichi wins, the initial market reaction would be a yen fall as markets price in the chance of delay in future rate hikes," said Naomi Muguruma, chief bond strategist at Mitsubishi UFJ Morgan Stanley Securities.

'DEFLATION' RHETORIC RE-EMERGES

Under pressure from then premier Abe, the BOJ in 2013 deployed radical stimulus that morphed into a complex policy package to lift anemic inflation up towards the bank's 2% target.

As rising raw material costs and a tight job market pushed up inflation and wages, the BOJ exited the policy in March and raised rates to 0.25% in July under governor Kazuo Ueda.

The departure of Prime Minister Fumio Kishida, who appointed Ueda and has broadly supported phasing out the massive monetary stimulus, alone is a blow to the bank's exit strategy, analysts say.

"Things won't get any better for the BOJ than when Kishida was prime minister, regardless of who wins the LDP race," said former BOJ board member Takahide Kiuchi, who is currently an economist at Nomura Research Institute. "The BOJ will find it really difficult to hike rates if Takaichi wins."

Even if Takaichi does not become prime minister, a strong performance in the race could help her land a key cabinet post and yield pressure on the next premier, some analysts say.

Currently economic security minister, Takaichi has the backing of reflationist-minded lawmakers and academics who played a key role in Abenomics such as Etsuro Honda, who was Abe's economic aide.

Abe stepped down as prime minister in 2020 and was assassinated in 2022.

Although his death and a pickup in inflation pushed reflationist lobbying to the background, big spending and ultra-low interest rates remain popular among conservative LDP supporters, complicating Tokyo's efforts to end its reliance on heavy stimulus.

Despite its institutional independence, the BOJ is sensitive to political discontent about its policy and has in the past become a target of public ire, with many blaming the decade-long economic stagnation that began in the late 1990s on premature tightening.

While only LDP party members and lawmakers vote in Friday's contest, some members of the public have praised Takaichi's economic plans.

"Among the nine candidates, she (Takaichi) clearly stated that she would protect the country and its people, and invest money in the areas where it's needed to drive the economic development and revive Japan's economy," said Tomoko Abo, a 59-year-old resident of Osaka. "Such thoughts make me feel that Japan has a bright future."

Nodding to political concerns over higher borrowing costs, Ueda said in a speech on Tuesday that Japan "must avoid returning to deflation."

"Regardless of who becomes the new LDP leader and whatever belief he or she might have, we hope to communicate closely with the new government," Ueda told a news conference.

There is also uncertainty on whether the other frontrunners would endorse further rate hikes. Ishiba, who had criticised the BOJ's negative interest rate policy, recently told reporters a complete exit from deflation was crucially important. Little is known on Koizumi's views on monetary policy.

While a Takaichi win could be the BOJ's worst-case scenario, the other candidates could also push back against its rate-hike plans if Japan's economy is hit by headwinds such as a yen spike and soft global demand, said Nomura's Kiuchi.

"Many candidates appear to endorse rate hikes because they help slow yen falls and inflation. But that could change once the economy weakens, and the focus shifts to slumping growth."

(Reporting by Leika Kihara; additional reporting by Yoshifumi Takemoto, Irene Wang and Brandon Matsumoto; editing by Sam Holmes)