The Bank of Japan (BOJ) on Friday disclosed an updated estimate regarding the country’s natural rate of interest as part of its efforts to improve communication as it ends an era of ultra-low rates. The release occurred amid increased market attention to how close the central bank‘s short-term policy rate has approached levels deemed neutral to the economy, which is pivotal to the pace and timing of additional hikes. In the updated estimate, Japan’s natural rate of interest, also known as the neutral rate that neither cools nor overheats the economy, stood in a range of around -0.9 percent to +0.5 percent, the central bank said.
The range, which consists of estimates using six models, was largely unchanged from a previous estimate showing Japan’s natural rate of interest at -1.0 percent to +0.5 percent. The natural rate of interest is defined as the level of the real interest rate that is neutral to economic activity and prices. Analysts have interpreted the BOJ’s estimate as meaning that if inflation were to hit its 2 percent target, the bank can raise its short-term rate at least to around 1 percent without cooling growth, as reported by Reuters.Â
Real rates stay very low
Given uncertainty surrounding the estimates of the natural rate, the BOJ would look at various data points to measure the degree of monetary accommodation, the paper said. The BOJ keeps short-term rates at 0.75 percent even though inflation has hovered around 2 percent for nearly four years, meaning inflation-adjusted, real borrowing costs remain very low.
By increasing borrowing costs to levels deemed neutral to the economy, the BOJ can remove what it perceives as excessive monetary stimulus. However, estimating the neutral rate is challenging, with different models yielding varying results. Major central banks use neutral rates as a benchmark but warn against overly relying on them in conducting monetary policy. In elevating interest rates toward levels deemed neutral to the economy, the BOJ will also assess how past rate hikes have affected Japan’s financial conditions, it said. While funding costs are on the rise, overall funding demand remains firm due to the economy’s recovery and an increase in large-scale corporate acquisitions, the BOJ said.
Underlying inflation measurement revised
The release of the new natural rate estimate followed the BOJ’s announcement on Thursday of a new indicator for measuring underlying inflation and updated data on Japan’s output gap. The revised output gap data showed demand exceeded supply capacity for a 15th straight quarter to hit +0.45 percent in the third quarter of 2025, overturning its previous estimate that had indicated excess supply for about five and a half years. The findings suggest intensifying labor shortages and solid domestic demand are propping up growth and inflation and could provide the BOJ further justification to raise rates, analysts say.Â
The series of disclosures followed a pledge by Governor Kazuo Ueda last week to boost communication on key policy themes and came amid growing market expectations for a near-term interest rate hike. Japanese government bond yields rose on Friday, with five-year yields hitting a record high, as the Middle East conflict and recent central bank signals heightened inflation concerns and led investors to reprice the path of rate hikes.
