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Rising sun, rising rates: Bank of Japan lifts rates to 31-year high

Investment Insights • Macro

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Rising sun, rising rates: Bank of Japan lifts rates to 31-year high

The Bank of Japan increased interest rates to a 31-year high at its meeting in June, raising the question about how much higher rates in Japan can go. In this Macro Flash Note, Economist Sam Jochim assesses the outlook for monetary policy in Japan.

Sam Jochim

Sam Jochim

The Bank of Japan (BoJ) lifted its policy interest rate from 0.75% to 1.00% at its meeting in June, with the Policy Board voting 7-1 in favour of the move. The number of voting members was reduced from nine to eight at the June meeting, with Governor Ueda unable to attend after being admitted to hospital. Ueda is expected to return for the July meeting and will find rates at their highest level since 1995 when he does so.

Inflation dynamics and the role of government subsidies

The decision to raise interest rates reflected the Bank’s view that downside risks to economic activity stemming from the situation in the Middle East have faded and the risk of underlying inflation increasing above 2% has risen.1 In part, this is due to the government program which subsidises energy for households, reducing the burden of higher prices.2

Inflationary pressures have been easing because of the program, which was active from January to March and will be reintroduced from July to September. In January, the year-on-year rate of inflation fell below the BoJ’s 2% target for the first time since March 2022 (see Chart 1). This was also the case when excluding fresh food prices, a measure of inflation that the BoJ likes to look at to gauge underlying inflationary pressures.

However, the Bank was keen to point out that this drop in inflation was driven by government programs that are temporary and there is a risk that underlying inflation deviates upwards to a level above 2%. To that end, the BoJ has started to publish a core inflation measure which excludes institutional factors. By that measure, inflation (excluding fresh food) rose from 2.5% to 2.8% year-on-year in April.

Market reaction and Policy Board bias

The decision to raise rates in June was priced in by markets. A hawkish bias emerged within the Policy Board from January to June, with dissenters voting to tighten monetary policy at each meeting during that period (see Chart 2). This could help explain the muted market reaction, with the yen flat against the US dollar on the day of the rate announcement.3 It is interesting to note that the dissenter at the June meeting preferred to leave rates unchanged, suggesting there may be less of an inherent bias within the Policy Board to raise rates further in future meetings.

Outlook

Nonetheless, the BoJ continues to highlight that its monetary policy remains accommodative. If inflation rises to the central bank’s 2% target, as it expects, then rates could go up between 0.25% and 1.5% while remaining within the BoJ’s estimated neutral range.4 As such, it is reasonable to expect another rate increase in 2026, though the Policy Board is likely to await confirmation that underlying inflation trends remain intact, suggesting that move is more likely to come in Q4.

In summary, the BoJ raised interest rates to a 31-year high at its June meeting, reflecting its view that risks to economic activity have faded and the risk of underlying inflation increasing above 2% has risen. While the Policy Board no longer has as clear a bias to raise rates, it retains the view that monetary policy is accommodative and further rate increases are therefore likely. The pace of rate hikes is likely to remain gradual though, with no move likely before Q4.

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