Bank of England: a skip, not a pause

At its meeting in December, the BoJ Policy Board voted unanimously to raise the policy rate by 25 basis points to 0.75%. That the decision was unanimous marked a break from the pattern of votes at the two previous meetings, in which rates were left unchanged despite two Policy Board members voting to raise them. This had been the first time two members had dissented in eight years and highlighted the tensions within the Policy Board.

Behind the curve

Inflation in Japan is on course to exceed the BoJ’s 2% target for the fourth consecutive year, a clear structural break from the years of below-target inflation which preceded this (see Chart 1). While the BoJ recognised this and started to raise rates, it fell behind the curve as real interest rates became extremely low and the central bank continuously guided that it was appropriate to raise rates but failed to do so.

Chart 1. Japan consumer price index inflation and BoJ real policy rate (%)¹

Source: LSEG Data & Analytics and EFGAM calculations. Data as at 19 December 2025.

Even after the latest interest rate increase, the BoJ noted that real interest rates are expected to remain very low and that monetary policy remains accommodative. The decision in December can therefore be likened to the BoJ taking its foot off the accelerator rather than stepping on the brake.

With underlying inflation forecast to be at or above the 2% target over the BoJ’s entire forecast horizon, it is reasonable to expect further policy rate increases.² The Bank of Japan has previously highlighted the importance of the spring wage negotiations, known as the Shunto, in realising this outlook. While the timing of the next rate hike is unclear, it is unlikely to come before there is more information available from the 2026 Shunto, making the June meeting the most likely date.

Determining the terminal rate

The key question at this point is what the terminal rate will be. The terminal rate is the peak interest rate the BoJ expects to reach in its monetary policy tightening cycle. Given the central bank forecasts inflation of 2% in fiscal year 2027, it is reasonable to expect the terminal rate to be consistent with the neutral rate. This is the interest rate which neither stimulates nor restricts the economy. The neutral rate must be estimated since it is unobservable, and the BoJ has estimated a range of 1.0-2.5%. This means that another rate hike would take the BoJ policy rate to the lower bound of its estimated neutral range.

However, given the BoJ noted real interest rates are “at significantly low levels” even after the latest rate increase, it is reasonable to expect rates to be increased by more than 25 basis points before the terminal rate is reached.³ Thus, a range of 1.25-1.75% appears more appropriate for the terminal rate. Taking an average pace of one rate hike every six months, this could be achieved either by the end of 2026 or the end of 2027.

Market reaction

The BoJ’s decision was well anticipated and the market reaction was relatively muted. At the time of writing, the Japanese yen has depreciated 1.1% against the US dollar, reversing the 1.0% increase it experienced against the dollar in the month leading up to the BoJ decision.

After the BoJ announcement, Japanese government bond (JGB) yields rose across the term structure. For the shorter maturity JGBs, this reflects a mixture of the higher policy rate and expectations of further interest rate increases. For the longer dated JGBs, the rise in bond yields also reflects the looser fiscal policy under Prime Minister Takaichi.⁴ Notably, the 10-year yield and the 30-year yield are at their highest level since 1999. (see Chart 2).⁵

Chart 2. Japanese government bond yields (%)

Source: LSEG Data & Analytics. Data as at 19 December 2025. Past performance is not indicative of future results.

In conclusion, the rate increase by the BoJ in December was widely expected given the central bank had fallen behind the curve and had been signalling such a move for some time. This helps explain why the market reaction was relatively muted, with the Japanese yen depreciating against the dollar and bond yields rising marginally. The key questions for the BoJ have become how much higher its policy rate will go and how long it will take to get there. In our view, barring any shocks, between two and four rate hikes over the next two years appear reasonable.

¹ The Bank of Japan’s real policy rate is calculated as the policy rate minus year-on-year CPI inflation.
² https://www.boj.or.jp/en/mopo/outlook/gor2510a.pdf
³ https://www.boj.or.jp/en/mopo/mpmdeci/mpr_2025/k251219a.pdf
⁴ https://www.reuters.com/world/asia-pacific/japan-passes-118-billion-extra-budget-fund-its-biggest-post-covid-stimulus-2025-12-16/
⁵ The Japanese government began issuing 30-year government bonds in September 1999