Japan’s bitter memories of its decades-long battle with deflation hang heavily over the central bank’s deliberations to take its first modest step away from ultra-loose monetary policy, even as inflation and wages creep up.

The appointment of Kazuo Ueda as Bank of Japan (BOJ) governor this year and mounting price pressures have fired up market chatter that the new chief might hasten an exit from the bold stimulus of his predecessor Haruhiko Kuroda.

But uncertainty over the wage outlook and emerging global economic weakness heighten the chance the BOJ will hold off tweaking its controversial yield curve control (YCC) policy at least until autumn, say three sources familiar with its thinking.

“In a country that has seen interest rates stay ultra-low for two decades, the shock of the BOJ’s first move could be enormous,” said one of the sources. “That’s enough to make the BOJ cautious.”

Japan has not seen interest rates rise since 2007, when the BOJ hiked short-term rates to 0.5% from 0.25% in a move later criticised for delaying an end to price stagnation.

Having taken part in Japan’s battle with deflation as BOJ board member from 1998 to 2005, Ueda knows all too well the danger of a premature exit from ultra-loose policy.

Wary of a wobbly recovery, he opposed the BOJ’s decision in 2000 to raise short-term rates to 0.25% from zero.

The bank drew significant political heat for that tightening and was forced to reverse course just eight months later and adopt quantitative easing.

Given the trauma of such ill-timed policy shifts, caution will be Ueda’s priority, the sources say, suggesting an end to YCC, which caps the 10-year bond yield around zero, could be some time away. That would mean more significant policy changes are even further down the track.

“Tweaking the yield cap alone may not do much harm to the economy, as long as short-term rates are kept low,” one of the sources said. “But the BOJ’s long, historical struggle with deflation can’t be taken lightly.”

SHIFTING PRIORITIES

One key difference between the BOJ’s and the market’s thinking lies in Japan’s inflation outlook. On the surface, conditions for phasing out a portion of the BOJ’s massive stimulus appear to be falling in shape.

Core consumer inflation hit 3.4% in April, holding above the BOJ’s 2% target for over an year, as companies continued to hike prices for a broad range of goods and services. Companies offered pay hikes not seen in three decades in this year’s wage talks with unions, heightening hope of a sustained rise in pay after decades of stagnant wage growth.

With robust domestic demand offsetting some of the external headwinds, the BOJ is widely expected to raise this year’s inflation forecasts at its next quarterly review in July.

But inflation is now less of a trigger for an exit than it was in the past, as policymakers focus on risks that could again upend the path toward a sustained recovery.

“If you know the U.S. economy could slow sharply due to aggressive rate hikes in the past, it’s natural for the BOJ to be cautious about phasing out stimulus,” a third source said.

Weakness in China, a major market for Japanese manufacturers, also casts doubt over whether companies can reap enough profits to sustain wage hikes next year.

To be sure, Ueda has left scope to tweak YCC in case inflation continues to overshoot the BOJ’s forecasts. At his debut policy meeting in April, he removed guidance pledging to keep rates at “current or lower levels.”

In a group interview last month, Ueda said the BOJ could tweak YCC “if the balance between the benefit and cost of our policy shifts.”

With Kuroda’s massive stimulus having failed to re-anchor inflation expectations around the BOJ’s target, however, Ueda has good reason to be cautious.

Ueda last month said eradicating Japan’s entrenched deflationary mindset remained a difficult challenge and warned moving too quickly on rates was more dangerous than not moving fast enough.

“The cost of waiting for underlying inflation to rise until it can be judged that 2% inflation has fully taken hold is not as large as the cost of making hasty policy changes,” he said.

U.S. stocks have defied fears of a recession, a banking crisis and soaring Treasury yields to rise 20% from their October lows – one definition of a bull market.

The benchmark S&P 500 index closed at a low of 3,577.03 on Oct. 12, 2022, down 25% from its all-time high after the Federal Reserve unleashed a series of bruising interest rate increases to fight decades-high inflation.

On Thursday, it closed up 0.6% at 4,293.93, amid growing optimism over the economic outlook and a rate hiking cycle that appears to be nearing its end. Here are some features of the index’s rally, and a look at where stocks might go from here.

While markets seldom rise in a straight line, the S&P 500’s journey from the bottom took 164 days – the longest 20% climb from a bear market low in five decades. Among the factors holding stocks back was a surge in Treasury yields to their highest levels in decades that dulled the allure of equities by offering investors the potential to earn attractive income in government-backed bonds.

A crisis that saw the biggest bank busts since the Great Recession also shook investor confidence, as did worries over a potentially catastrophic fight over lifting the U.S. debt ceiling.

The narrow breadth of the S&P 500’s rally has been a concern for some investors, with just seven stocks – Alphabet, Apple, Microsoft, Amazon, Meta, Nvidia and Tesla — responsible for almost all of the index’s gains this year. Many investors view these stocks as safe bets in uncertain times. Their gains were also driven by excitement over advances in artificial intelligence.

More recently, however, the market’s gains have shown tentative signs of broadening out to other stocks. Meanwhile, volatility has subsided – not only in stocks, but in Treasuries and currencies.

One reason for the calm in markets is investors’ belief that the Fed is unlikely to deliver many more of the rate hikes that shook asset prices last year.

Investors have also been encouraged by evidence showing that the U.S. economy continues to be resilient in the face of the central bank’s monetary tightening, while inflation slowly cools. The U.S. Citigroup (NYSE:C) Economic Surprise Index shows U.S. economic data has in aggregate topped market expectations, helped by stronger than expected numbers for employment and consumer spending.

A 20% gain from bear market lows has in the past heralded further upside for stocks.

In four of the last six bear markets, the S&P went on to rise 20% or more in the six months after hitting this milestone.

The dollar on Friday held near the previous day’s two-week low against a basket of peers after a spike in weekly jobless claims raised hopes that a peak in U.S. rates was near, while the focus turned to the upcoming week packed with central bank meetings.

The number of Americans filing new claims for unemployment benefits surged to the highest in more than 1-1/2 years last week, data on Thursday showed, though layoffs are probably not accelerating as the data covered the Memorial Day holiday, which could have injected some volatility.

Nonetheless, that was enough to knock the U.S. dollar to a more than two-week low against a basket of currencies in the previous session, as investors took the data as a sign that the U.S. labour market was slowing.

The dollar index last stood at 103.42, having lost more than 0.7% in the previous session, its largest daily decline since mid-March.

The index, which measures the U.S. currency against six major peers, is down 0.6% for the week, set for its biggest weekly fall also since mid-March when fears about the health of the banking sector roiled markets.

The euro was flat on the day at $1.07735 having gained 0.78% on Thursday to a two-week intraday high due to the dollar sell off. Sterling, which jumped nearly 1% on Thursday, was at $1.2545 just off a near one-month high.

The dollar rebounded against the Japanese yen however, rising 0.48% to 139.6 after Bank of Japan Governor Kazuo Ueda reiterated the central bank’s resolve to keep monetary policy ultra-loose.

Markets are now turning their attention to the coming week which will see the Federal Reserve, the European Central Bank (ECB) and the Bank of Japan (BOJ) announce interest rate decisions following their respective policy meetings.

The Fed takes centre stage, with money markets leaning toward a pause, though they have priced in a 25% chance that the U.S. central bank delivers a 25 bps rate hike.

“Before the meetings that we had this week I would have said I was expecting the status quo, now I’m not excluding something surprising, because a central bank like Canada, that had clearly telegraphed it was on hold, raised rates and said it was concerned about inflation,” said Chester Ntonifor, FX strategist at investment provider BCA.

The Bank of Canada on Wednesday lifted rates after a four-month pause because of surprisingly strong household spending and high core inflation.

“For me, it’s clear that the ECB is going to stay hawkish, I don’t think they’re going to be more hawkish than what’s already priced in by markets, what is interesting is the Fed,” Ntonifor said.

Ntonifor added that the message markets took concerning the possibility of U.S. rate cuts later in the year would be important for currencies.

The Canadian dollar was last at C$1.334 per dollar, not far from the C$1.3321 hit on Wednesday, its strongest in a month after the central bank’s move.

The Turkish lira tumbled more than 1% against the dollar to a record low after President Tayyip Erdogan appointed Hafize Gaye Erkan, a finance executive in the United States, to head Turkey’s central bank.

“A return to policy orthodoxy seems inevitable given the materially diminished foreign exchange reserves and 40% inflation,” said Mohammed Elmi, senior portfolio manager for emerging markets fixed income at Federated Hermes (NYSE:FHI).