Analysis:Market rout tests BOJ's upbeat view of financial conditions

The recent stock market downturn is prompting analysts to scrutinize the Bank of Japan's (BOJ) assessment of financial conditions, a crucial aspect of its monetary policy framework. After a sharp sell-off in AI stocks, markets have begun to stabilize, leading many to anticipate an interest rate hike as early as December. However, this market volatility has tested the BOJ's belief that robust AI demand will fuel economic growth, with the wealth effect from soaring stock prices enhancing households' and businesses' spending power.

The central bank's emphasis on financial conditions, which gauges how near its policy rate is to a neutral level, has come under the microscope. Former BOJ official Tetsuya Inoue notes that while the BOJ maintains that financial conditions remain loose, persistent instability in asset prices could dampen growth by dampening corporate sentiment and household spending.

The BOJ has long emphasized the need for continued rate hikes to counter upward price risks and avoid underlying inflation surpassing its 2% target. It has also justified rate hikes by highlighting loose financial conditions, citing low real borrowing costs, strong corporate funding demand, and increasing bank lending. However, the BOJ also acknowledges that asset prices, such as stock prices and exchange rates, play a role in shaping financial conditions, as they influence household and corporate spending.

In the past quarter, Japanese households' stock holdings soared to 486 trillion yen ($3.08 trillion), accounting for 19.3% of total wealth. This wealth effect, while smaller than in the US, could still have a significant impact on consumption, particularly among younger generations who have been heavily invested in stocks as part of the AI boom.

At the BOJ's latest policy meeting, the board signaled increased focus on financial conditions, with some members advocating for a tripartite assessment incorporating the real interest rate gap, corporate finance, and the bank lending channel, alongside asset prices. Despite the BOJ's reassurances that financial conditions remain accommodative, there is a growing divergence among board members regarding the impact of past rate hikes and the potential consequences for growth.

The BOJ's Governor Kazuo Ueda is expected to address the market rout's impact on financial conditions in a speech scheduled for November 30, ahead of the BOJ's upcoming policy meeting on December 17 and 18. The outlook remains uncertain, as the market's future behavior is yet to be determined.