Bank of Japan Raises Rate to 1.25%, Highest in 31 Years; Yen Falls

On September 18, the Bank of Japan (BOJ) announced a 25-basis-point hike in its policy rate to 1.25%, the highest level in 31 years. This follows the BOJ's rate increase in June this year and signals an acceleration from its previous pace of roughly one rate hike every six months since March 2024.

This is the second rate hike by the BOJ this year, indicating that its pace of tightening—previously averaging about one hike every six months since March 2024—is accelerating.

As major central banks worldwide face renewed inflationary pressures, the BOJ's latest move has drawn significant attention. Particularly against the backdrop of the Federal Reserve's rate hike this week and persistently high yields on long-term U.S. Treasury bonds, market focus is centered on whether the yen can appreciate further and at what speed the BOJ will continue to tighten monetary policy.

The BOJ stated that with underlying inflation approaching 2% and financial conditions remaining accommodative, it would "continue to raise the policy rate and adjust the degree of monetary easing." However, market analysts noted that this language was highly consistent with previous statements, offering no clear signal of accelerated tightening.

Following the announcement, the yen weakened.

Hawkishness Falls Short of Expectations

Voting results revealed ongoing divisions within the BOJ regarding this rate hike. Two members voted against the decision, citing reasons such as:

• Recent inflation falling below 2%
• Economic conditions not yet being sufficiently strong
• The absence of a significant acceleration in current economic and price trends compared to earlier periods

Nevertheless, the overall policy stance indicates a notable shift in the BOJ's assessment of inflation risks.

In its latest decision, the BOJ noted that Japan's Consumer Price Index (CPI) has risen moderately recently, the pass-through of wage increases to selling prices by companies continues, medium- to long-term inflation expectations are rising, and underlying CPI inflation is now close to 2%.

More notably, the BOJ placed greater emphasis for the first time on the importance of preventing inflation from deviating upward from its 2% target. The BOJ believes that as corporate behavior shifts further toward raising wages and prices, and as medium- to long-term inflation expectations rise, there is a risk that underlying CPI inflation could overshoot the 2% price stability target.

This assessment served as a key basis for the current rate hike.

Economic Outlook

Regarding the economic outlook, the BOJ maintained that Japan's economy remains in a moderate recovery process. Although some regions have shown weakness and Middle East tensions may exert some drag on economic activity, growth in global demand related to artificial intelligence (AI) and government policy measures continue to support the economy.

The BOJ specifically highlighted that Producer Price Index (PPI) increases have remained elevated recently, driven by:

• Expanding AI-related demand
• High crude oil prices
• Yen depreciation

Meanwhile, the impact of rising import prices is gradually passing through to consumer prices, and the trend of companies passing wage increases onto selling prices persists.

Accommodative Conditions Expected to Remain

The BOJ also emphasized that even after this rate hike, accommodative financial conditions are expected to remain. This statement helped temper market interpretations of an overly hawkish policy path.

The statement particularly stressed that preventing underlying CPI inflation from breaking above the 2% price stability target—and thereby adversely affecting the economy—is a crucial perspective in current policy considerations.

However, the BOJ did not provide a specific timeline for the next rate hike, instead emphasizing that it would determine the timing and pace of future policy adjustments after assessing the likelihood of economic and price developments meeting its baseline scenario and evaluating related risks. Key variables to watch include:

• The situation in the Middle East
• AI-related demand
• Foreign exchange trends

BOJ Governor Kazuo Ueda stated during his afternoon press conference that robust AI demand, the recent rebound in crude oil prices, and persistent yen weakness have collectively kept producer prices elevated, supporting continued inflation. He also noted the need to avoid negative impacts from aggressive rate hikes. While interest rates have tightened, bank lending and capital markets remain accommodative.

Yen Falls Despite Rate Hike

After the BOJ announced the rate hike, the yen weakened.

Market participants pointed out that the 25-basis-point hike had largely been priced in, meaning the move itself was insufficient to provide sustained support for the yen. In contrast, the Fed's hawkish rate hike earlier this week had already put pressure on the yen. If investors believe the BOJ's future tightening path cannot keep pace with the Fed, the USD/JPY pair could move back toward the 160 level.

Earlier this month, the yen experienced a notable rally. At that time, expectations for faster BOJ policy tightening intensified, while unwinding of yen carry trades and speculation that Japanese pension funds might increase domestic asset allocations also drove rapid yen appreciation.

However, as expectations for the BOJ's rate hike were gradually digested by the market, the momentum behind the yen's earlier gains faded.

Consequently, a critical question facing the yen now is: although the BOJ has resumed rate hikes, can its pace of tightening truly catch up with that of the United States?

Broader Context: U.S. Pressure on Yen Policy

It is worth noting that the yen issue is no longer solely a matter of the BOJ's monetary policy.

U.S. Treasury Secretary Scott Bessent has spent the past several months pressuring Japan to address the fiscal and monetary factors behind the weak yen, including tightening fiscal policy and pushing the BOJ to raise interest rates. Bessent is concerned that sell-offs in Japanese government bonds could spill over into the U.S. Treasury market.

Previously, Japan sought U.S. assistance to stabilize the yen, but Washington's policy approach extended beyond merely supporting currency intervention. In late July, Japan and the U.S. conducted a joint operation to buy yen, but the resulting strength proved unsustainable. From late August to early September, Bessent again reiterated pressure on Japan.