Bank of Japan Lifts Rates to 31-Year High, Signals Policy Shift

The Bank of Japan raised its policy rate to 1.25% from 1% on Friday, the highest level in 31 years, as it flagged a shift in its policy focus toward containing broadening price pressures. The decision, made by a 7-2 vote, was widely expected but failed to lift the yen, which initially fell as investors focused on the lack of explicitly hawkish guidance and two dissenting board members.

Dovish board members Toichiro Asada and Ayano Sato opposed the move, arguing for patience in pushing up borrowing costs. The yen weakened to 156.91 per dollar after the announcement, as the standard 25-basis-point increase and the dissents tempered expectations of bolder tightening.

The hike, the first in three months, follows rate increases by the European Central Bank and the US Federal Reserve, underscoring global central banks' focus on inflation risks driven by an Iran war-induced energy cost spike, expansionary fiscal policies and surging demand for AI investment. It brings the BOJ's policy rate closer to levels it considers neutral for the economy, marking another step away from decades of ultra-low rates that made the yen a cheap global funding currency.

BOJ Governor Kazuo Ueda said that with underlying inflation approaching 2%, the bank's policy phase had changed. "If risks of underlying inflation overshooting 2% materialise, that could have a negative impact on Japan's economy," he told a news conference. "It's important to stabilise underlying inflation at 2%."

In its statement, the BOJ said economic and price developments were moving in line with its baseline forecast, but warned of a risk that underlying inflation could deviate from its 2% target. It noted that wholesale inflation remains elevated and that price pressures from business-to-business trading have started to spill over into consumer prices, as companies continue to pass on higher wages and inflation expectations heighten.

Analysts said the statement and the two dissents left doubts about how cautious the BOJ would be in further tightening. The BOJ exited a decade-long stimulus in 2024 and has raised rates roughly twice a year, including in June. Friday's move takes the rate within the BOJ's estimated 1.1% to 2.5% range for Japan's nominal neutral rate, raising questions about how far it could eventually hike. The BOJ still lags global peers, with its policy rate below the ECB's 2.5% and the Fed's 3.75%-4.00% range.

Core consumer inflation held steady near the BOJ's 2% target in August, data showed on Friday. Analysts polled expect the BOJ to hike to 1.5% by end-March next year and to 1.75% in the second quarter of 2027, with most seeing a terminal rate of at least 1.75%.

Markets had nearly fully priced in the September hike after hawkish signals, including the BOJ's July warning of an inflation overshoot from soaring fuel costs, rising import costs from a weak yen and strong AI demand. US Treasury Secretary Scott Bessent said he voiced strong support for "decisive" monetary steps to combat yen weakness in a meeting with Ueda this month on the sidelines of a G20 finance leaders' gathering. In agreeing to join Japan's yen-buying intervention, Bessent also urged Prime Minister Sanae Takaichi's administration to avoid ramping up fiscal stimulus, a move running counter to the BOJ's efforts to rein in inflation, sources said.

Many BOJ officials, including Ueda, have remained vague on the potential speed and degree of future rate hikes, arguing that much depends on the inflation outlook and how past rate hikes affect financial conditions.