Japan’s central bank on Thursday began its final policy meeting of the year, with investors widely expecting a landmark interest rate increase that would take borrowing costs to their highest level in three decades.
The Bank of Japan’s decision, due on Friday, is seen as another step in its long-awaited shift away from ultra-loose monetary policy.
Data from LSEG show markets pricing in an 86.4% probability that the BOJ will raise its benchmark rate by 25 basis points to 0.75%, a level last seen in 1995.
Such a move would underline the central bank’s commitment to policy normalisation after decades spent battling deflation with near-zero or negative interest rates and massive bond purchases.
Rate hike priced in, market to focus on Governor’s comments
A rate increase would mark a significant moment for the BOJ, which has only recently begun dismantling the framework that defined its monetary policy for a generation.
Even after the expected hike, policymakers believe real interest rates will remain negative, suggesting further tightening could follow.
“A 25 bp hike is almost fully priced by market participants,” said Min Joo Kang, senior economist for South Korea and Japan at ING Think.
The market’s focus will be on Governor Ueda’s comments. We don’t expect Ueda to send any hawkish messages, given growing concerns about rising market rates.
BOJ Governor Kazuo Ueda has repeatedly stressed caution, noting the difficulty of estimating Japan’s so-called neutral rate, which neither stimulates nor restrains economic growth.
The central bank currently places that rate in a wide range of 1% to 2.5%, highlighting the uncertainty surrounding the pace and endpoint of future hikes.
Gregor MA Hirt, global multi-asset chief investment officer at Allianz Global Investors, said markets would scrutinize the tone and detail of the BOJ’s communication.
Signals about the terminal rate and comments on currency weakness are likely to shape the immediate reaction.
Global implications of rate hike
The BOJ’s decision is being closely watched well beyond Japan, largely because of the yen carry trade.
For years, investors have borrowed cheaply in yen and invested the proceeds in higher-yielding assets overseas, particularly in the United States.
A rate hike could strengthen the yen and reduce the appeal of such trades, potentially triggering shifts in global capital flows.
While that could help rein in imported inflation at home, it also risks volatility in currency and bond markets abroad.
Vincent Chung, a fixed-income portfolio manager at T Rowe Price, said the BOJ could raise rates twice in 2026 if real rates remain deeply negative.
He added that any yen weakness following cautious guidance would likely be short-lived.
Growth concerns complicate the outlook
While inflation has exceeded the BOJ’s 2% target for 43 consecutive months, the broader economy remains fragile.
Revised data showed Japan’s economy contracted more sharply than initially estimated in the third quarter, shrinking 0.6% quarter on quarter and 2.3% on an annualised basis.
A stronger yen and higher borrowing costs could further weigh on consumption and investment, even as policymakers try to strike a balance between controlling inflation and supporting growth.
Rising yields add pressure to public finances
Higher rates also carry implications for Japan’s heavily indebted government.
Bond yields have climbed sharply, with 10-year Japanese government bond yields hovering near 18-year highs at around 1.97%.
If yields were to rise to 2.5%, Japan’s borrowing costs could double, according to a recent Nikkei report.
Interest payments are projected to reach 16.1 trillion yen in fiscal 2028, up from 7.9 trillion yen in fiscal 2024, even as the government rolls out its largest stimulus package since the pandemic.
ING Think said recent market reactions to comments about the neutral rate may have been overdone, emphasising that the concept is inherently imprecise.
The BOJ is expected to closely monitor indicators such as spring wage negotiations, lending activity and the yen’s exchange rate as it assesses the impact of higher rates.
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