The Bank of Japan has increased interest rates on Friday to levels that have not been reached in three decades and has indicated its preparedness to increase rates further. This is a significant step in completely abandoning several decades of intense monetary support and near-zero interest rates.
The central bank has increased the short-term interest rate to 0.75 per cent from 0.5 per cent in the first rise since the beginning of the year. The raise has come through a unanimous vote. The new rate is the highest since 1995. This was when Japan was trying to recover from the shock of the burst of an asset bubble that forced the BOJ into a battle against deflation. “Wages and inflation are still expected to continue increasing,” says the BOJ
This action also reflected the view the central bank has been expressing, which perceives Japan as on the right track toward attaining the target inflation rate of 2 per cent through wages. Since real interest rates are presently at very low levels, the BOJ “will continue to raise interest rates” if its forecast for the future comes true.
The BOJ retained its expectation that the underlying inflation will reach its 2% target in the second half of the three-year projection period to fiscal 2027. However, two hawkish members, Hajime Takata and Naoki Tamura, were of the opposite opinion. Hajime said the underlying inflation has already met the target, and Naoki said it will meet it as soon as the middle of the three-year projection period.
Yen Weakens, Bond Yields Increase Following News
Markets are awaiting the news briefing that Governor Kazuo Ueda may give after the meeting for information regarding further rate hikes. These steps could have international market ramifications since the yen is perceived as an inexpensive source of funding for investment.
“Since the yen has been a principal funding currency for such a prolonged period, we anticipate the Bank of Japan to proceed cautiously in dealing with its monetary policy normalisation, in addition to making clear signals about its future courses of action,” said Mel Siew, Asia Credit Portfolio Manager, Muzinich & Co, Singapore.
The yen weakened by over 0.3 per cent to 156.02 to the dollar following the policy announcement, which was widely expected. The benchmark 10-year yield of the Japanese government bond increased by 3.5 basis points, touching a high of 2.0 per cent, its strongest position since May 2006.
A tough communication challenge is posed to Ueda. In light of Japan’s sensitive economy, Ueda is expected to be cautious and cannot afford to set a target pace for rising rates. At the same time, analysts expect him to send a tough monetary tone to steer away from a possible decline in the currency value, which would boost inflation.
The hike on Friday to 0.75 per cent would make rates nearer to levels that would be considered neutral for the economy. These levels are estimated by the BOJ at between 1 per cent and 2.5 per cent. All this adds complexities for the BOJ on how much further it would like to raise rates.
The BOJ wrapped up its ten-year massive expansion policy last year and has raised interest rates twice, including an increase to 0.5 per cent from 0.25 per cent. The bank is of the view that it is on the threshold of achieving the 2 per cent inflation target.
Because of persistently high food prices, keeping inflation higher than target for almost four years, more and more members of the BOJ Board are ready to vote for a rate increase so that they do not remain late in combating higher inflation.
On Friday, data showed that core consumer prices rose to 3.0 per cent in November, unchanged for the second month in a row and significantly above the BOJ’s target level.
Recent yen depreciation, which increases import prices and inflation, also encouraged the BOJ to persuade dovish Premier Sanae Takaichi’s administration to increase interest rates again. The economy has been resilient in the face of new US tariffs. Recent surveys by the central bank found that company confidence reached a four-year high, and most firms are on track to keep giving big pay rises next year.
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