A widely expected move could still unsettle markets as investors await Kazuo Ueda’s clues about how far tightening may go.
The Bank of Japan is preparing to raise its key interest rate to its highest level in 31 years. The decision is expected on Friday amid growing inflationary risks, particularly due to the rapid rise in oil prices.
If the increase goes ahead, it will be the first move of its kind in the past three months. The rate will approach the level the Japanese central bank considers neutral for the economy. In doing so, Japan will continue to move away from the ultra-low-rate policy that has encouraged a weaker yen for decades and made it a popular currency for international financing.
The Bank of Japan’s decision will extend the global tightening of monetary policy. The European Central Bank has already raised rates, while the U.S. Federal Reserve is expected to take a similar step this week. The threat of a renewed acceleration in inflation remains at the center of attention for leading central banks.
Markets have almost fully priced in a rate hike, so investors will be watching for signals from Bank of Japan Governor Kazuo Ueda about future decisions and the pace of policy tightening.
Markets are divided between those who believe that tougher rhetoric from the Bank of Japan could lower bond yields by easing concerns that the central bank is falling behind inflation, and those who expect yields to rise as forecasts for the terminal rate are revised.
– Katsutoshi Inadome, senior strategist at Sumitomo Mitsui Trust Asset Management
Following the two-day meeting, which will conclude on Friday, the rate could rise from 1% to 1.25%. Board member Toichiro Asada, who opposed a hike in June, may again decline to support the decision.
Given the need to assess the impact of previous moves on financial conditions, a significant portion of Bank of Japan officials are likely to favor a 25-basis-point increase rather than a more aggressive move.
Inflation risks complicate the Bank of Japan’s decision
In 2024, the Bank of Japan ended a decade of large-scale economic stimulus and has since raised rates several times, including in June. In July, the regulator left them unchanged but warned of the risk that inflation could exceed its target.
Factors putting pressure on prices included higher fuel costs, more expensive imports due to the weak yen, and strong demand linked to the development of artificial intelligence. Kazuo Ueda has previously said that underlying inflation had approached the 2% target, meaning the central bank must pay particular attention to inflationary threats.
Analysts estimate that the rate could rise to 1.5% by the end of March next year and to 1.75% in the second quarter of 2027. Most experts expect the terminal rate to be at least 1.75%.
The Bank of Japan governor faces a difficult task at the press conference following the meeting. The regulator wants to avoid promising another early hike, but repeating its cautious stance and reliance on economic data could trigger another sell-off in the yen. This, in turn, could increase the cost of imported goods.
Overly hawkish rhetoric also poses risks to the government bond market. It is already experiencing a sell-off that has pushed bond yields to their highest level in three decades amid concerns about the state of Japan’s public finances.
Further rate hikes remain on the agenda
A rate increase to 1.25% would bring it closer to Japan’s estimated neutral-rate range of 1.1% to 2.5%. This is the level at which monetary policy neither restrains nor stimulates economic growth. It could intensify debate over how far the Bank of Japan is prepared to go in the future.
Kazuo Ueda has stressed that the regulator has no predetermined terminal rate. At the same time, central bank officials believe that several more increases are possible before the neutral level is reached. Board member Naoki Tamura estimates the neutral rate at around 2%.
Delaying necessary rate increases would create adverse effects, although the pace will depend on economic, price and financial conditions at the time.
– a source familiar with the Bank of Japan’s position
Another factor for the regulator is the expansionary fiscal policy of Prime Minister Sanae Takaichi. Large-scale government support could intensify inflationary pressure and complicate the central bank’s task of maintaining price stability.
With high debt burdens and concerns about fiscal dominance, the risk of rising inflation expectations is increasing. Central banks will have to respond decisively to future shocks to protect their independence, preserve confidence and fulfill their mandate to ensure price stability.
– Kristalina Georgieva, Managing Director of the International Monetary Fund
Thus, the Bank of Japan’s decision will be an important test of its ability to contain inflation without placing excessive pressure on the economy, the yen and the government bond market.
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