The Bank of Japan can start raising interest rates from early 2024, given that inflation will likely remain above the central bank's 2 percent target and wage dynamics are also changing, the Organization for Economic Cooperation and Development said Thursday.
In its economic survey report on Japan, the OECD also urged the BOJ to make its yield cap program more flexible, warning of renewed market pressures to scrap it.
The Paris-based club stressed the need for heavily indebted Japan to draw up a "clear and credible" road map to restore its fiscal health, the worst among advanced economies, as higher interest rates would push up debt-servicing costs.
The recommendations came as the OECD expects Japanese core consumer prices, excluding energy and volatile fresh food, to rise around 2.0 percent in both 2024 and 2025.
"OECD projections of sustained inflation around 2 percent, increasing wage growth and a closing of the output gap imply a gradual increase in the policy rate is warranted, starting from early 2024," the report said.
The BOJ is closely watching whether Japan will achieve robust wage growth, with the outcome of upcoming "shunto" negotiations between labor unions and management in greater focus. Market expectations are heightening that the central bank will end its negative interest rate, probably in April, following the wage talks.
Prime Minister Fumio Kishida is asking Japanese companies to raise pay so wage growth can outpace inflation, which has remained well above 2 percent for more than a year. Business leaders have also underscored the need to reward workers with higher pay, though uncertainty remains over whether smaller firms will follow suit.
OECD Secretary General Mathias Cormann said the BOJ is taking a more "prudent" approach as it seeks to avoid premature tightening and awaits more data.
"I understand the historical context when it comes to inflation and deflation in Japan," Cormann told a press conference. "Our assessment is slightly more optimistic (than the BOJ's) when it comes to what we expect to happen to inflation in Japan moving forward."
Under the BOJ's program to keep borrowing costs extremely low to support households and businesses, short-term interest rates are set at minus 0.1 percent, while the central bank has allowed 10-year Japanese government bond yields to rise above its previously rigid 1.0 percent following recent tweaks.
The OECD proposed as options raising the 10-year yield cap further and adopting a shorter-term yield target.
While the government is seeking to curb spending that has swelled in recent years to cope with the COVID-19 pandemic and high inflation, achieving its target of a primary budget surplus in fiscal 2025 is still a tall order.
Kishida has ordered an expansion of the Cabinet-approved 112.07 trillion yen ($770 billion) budget for fiscal 2024 by allocating more funds for emergency use in the aftermath of an earthquake that ravaged central Japan in January.
The government's growing reliance on reserve funds, which can be used at its own discretion without parliamentary approval, has come under greater scrutiny. Some unused funds are diverted for defense expenditures with Japan aiming to spend around 43 trillion yen in the five years to fiscal 2027.
The use of supplementary budgets and reserve funds "should be limited to large macroeconomic shocks with a more concrete definition under which circumstances they can be used," the OECD said, calling for an external assessment, possibly by an independent fiscal institution, of whether such spending has indeed been used to respond to crises.
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