Bank of Japan raises rates to 1.25%, highest since 1995, as weak yen fuels inflation risks

The Bank of Japan (BOJ) raised its policy interest rate to 1.25 per cent on Friday, taking borrowing costs to their highest level in more than three decades as the central bank steps up its response to inflation and a weak yen.

The BOJ raised its short-term policy rate from 1 per cent in a 7-2 vote. The move was the first rate increase since June and marked another step away from the ultra-low interest rates that defined Japan’s monetary policy for years.

The central bank said underlying inflation was approaching its 2 per cent target and financial conditions remained accommodative.

The rate hike came as Japan faces pressure from higher energy costs and a weak yen. A weaker currency makes imports more expensive and can push up the cost of fuel, food and other goods.

Japan’s core consumer inflation rose 1.7 per cent year-on-year in August, official data showed on Friday. The increase was below the 1.8 per cent market forecast and eased from 1.8 per cent in July.

An index that excludes both fresh food and fuel rose 1.9 per cent in August. The BOJ closely watches this measure because it gives a clearer picture of underlying price pressure.

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Core inflation has remained below the BOJ’s 2 per cent target for eight months. However, government subsidies have helped reduce some pressure on household energy costs. At the same time, higher fuel prices and the weak yen have increased concerns about inflation moving higher.

Why did the BOJ raise rates?

The BOJ has been gradually moving away from its long period of monetary stimulus.

The central bank ended its decade-long stimulus programme in 2024 and has raised rates several times since then. It increased the policy rate to 1 per cent in June and kept it unchanged in July.

The latest hike takes the rate closer to the BOJ’s estimated neutral range of 1.1 per cent to 2.5 per cent. The neutral rate is the level at which monetary policy is expected to neither support nor slow economic growth significantly.

The weak yen has also become an important issue for policymakers.

The yen was trading around 156.23 against the US dollar before the BOJ decision. A wide interest-rate gap between Japan and the US has put pressure on the Japanese currency.

The US Federal Reserve recently raised its policy rate to a 3.75-4 per cent range. A wider gap between US and Japanese rates can make dollar assets more attractive compared with yen assets, putting further pressure on the Japanese currency.

What happens to the yen and markets?

The yen weakened ahead of Friday’s decision, while Japanese stocks gained.

Japan’s Nikkei was up about 0.9 per cent in early trading. The broader MSCI Asia-Pacific index excluding Japan rose 0.55 per cent, while South Korea’s KOSPI gained about 2 per cent.

Investors are now watching BOJ Governor Kazuo Ueda’s comments for clues about the pace of future rate increases.

The BOJ has so far avoided giving a clear timetable for further hikes. Officials have said future decisions will depend on inflation, economic activity and financial conditions.

The timing of further increases will also depend on how the weak yen, energy prices and global interest rates affect Japan’s inflation outlook.

A Reuters poll before the decision showed economists expected the BOJ’s policy rate to rise to 1.5 per cent by March 2027 and 1.75 per cent by the second quarter of 2027.