The Bank of Japan raised its interest rate by a quarter percentage point to 1.25% on Friday, the highest level since April 1995, continuing its retreat from the accommodative monetary policy it pursued for decades amid concerns that higher oil costs and a weaker yen could feed through to consumer prices.
Seven members of the monetary policy board voted in favor of the increase, while two opposed it and preferred to keep the rate at 1%, at the conclusion of a two-day meeting.
Yen falls after decision
This was the first increase since June, when the bank raised the rate from 0.75% to 1%. Shortening the interval between the two increases to 3 months reflects policymakers’ concern that inflation could become entrenched and that imported energy costs could rise because of the war in the Middle East.
The increase, which had been widely expected, failed to support the Japanese currency. The yen fell about 0.7% to around 157.1 yen per dollar at the time of publication, while also declining against the euro to around 180.4 yen.
Investors focused on the two dissenting votes and the lack of an explicit commitment to raise interest rates again at the next meeting, reducing bets on faster monetary tightening in the coming months.
Hirofumi Suzuki, chief foreign-exchange strategist at SMBC in Tokyo, said the rate increase was in line with market expectations, but the two dissenting votes came as a surprise and made the decision appear less hawkish.
The yen declined even though higher interest rates typically make a currency more attractive, as the gap between Japanese and US yields remains wide after the Federal Reserve raised its interest rate this week to a range of 3.75% to 4%.
No fixed pace for increases
Bank of Japan Governor Kazuo Ueda said at a news conference following the meeting that the bank had not ruled out a larger increase of half a percentage point or rate hikes at consecutive meetings if inflation risks rose sharply.
Ueda said there was no predetermined pace for rate increases, such as moving once every 3 months, adding that the board would decide at each meeting based on developments in prices, wages, the economy and financial markets.
He added that the bank sought to act preemptively to prevent core inflation from exceeding its 2% target, sparing the economy from potentially sharp rate increases later that could have unintended effects on growth and asset prices.
Ueda said a renewed increase in energy costs could push up wholesale price inflation and then feed through to consumers, stressing that monetary policy does not target a specific yen level but monitors the impact of currency movements on domestic inflation.
Inflation approaches the bank’s target
Data released by Japan’s Statistics Bureau on Friday showed consumer prices rising 1.9% in August year on year, while the core index excluding fresh food increased 1.7%.
The index excluding fresh food and energy rose 1.9%, indicating that domestic price pressures are nearing the bank’s target, even as government support for energy bills kept headline inflation below 2%.
The Bank of Japan said wholesale price inflation remained high and that companies had begun passing higher transaction costs on to consumers, warning that core inflation could exceed its 2% target.
In a July report, the bank forecast average core inflation of 2.5% during fiscal 2026, driven by higher oil prices, a weaker yen and rising semiconductor prices as global demand linked to artificial intelligence grows.
The report projected that Japan’s economy would grow 0.6% during the current fiscal year, warning that higher oil prices were squeezing corporate profits and households’ real incomes, despite AI-related investment and wage increases supporting economic activity.
Monetary policy normalization continues
The decision marks the latest step in the monetary policy normalization process that began in March 2024, when the Bank of Japan ended negative interest rates and yield curve control after years of broad stimulus aimed at combating deflation and weak demand.
Despite raising the rate to 1.25%, the bank believes financial conditions remain accommodative, with real interest rates still negative after taking inflation into account, while corporate borrowing costs remain low relative to profits.
The increase means borrowing costs for companies and households will gradually rise, including for some housing loans, while returns on savings and banks’ profit margins improve. Future increases will depend on the path of oil prices, the yen and wages, and the extent to which these factors feed through to consumer prices.
