The Bank of Japan is preparing for higher interest rates, but rising government bond yields, political pressure from Prime Minister Sanae Takaichi’s administration and concerns over Japan’s massive public debt are complicating the central bank’s path toward policy normalisation.
The Bank of Japan’s (BOJ) journey towards higher interest rates is becoming increasingly complicated—not because inflation has faded, but because Japan’s bond market is sending warning signals.
While the central bank has been laying the groundwork for another rate hike after ending years of ultra-loose monetary policy, a sharp rise in Japanese government bond (JGB) yields is creating fresh challenges. Political pressure from Prime Minister Sanae Takaichi’s administration to keep borrowing costs under control is adding another layer of complexity, raising questions over how independently the BOJ can continue its policy normalisation.
Rising bond yields become the biggest hurdle
Government bond yields in Japan have climbed steadily in recent months as investors grow concerned over the government’s expansionary fiscal plans and rising debt burden.
The benchmark 10-year Japanese government bond yield touched 2.805% on Monday, edging closer to the psychologically important 3% mark, a level many market participants believe could trigger another round of bond selling.
Higher yields increase borrowing costs for the Japanese government, which already carries the largest debt burden among developed economies.
Why the government is worried
Prime Minister Sanae Takaichi has repeatedly indicated that maintaining stability in the bond market is a priority.
According to Japanese media reports, Takaichi urged BOJ Governor Kazuo Ueda during a meeting earlier this year to purchase more government bonds if necessary to prevent excessive increases in long-term interest rates.
More from BusinessSeveral senior members of her administration have also questioned the pace at which the BOJ is shrinking its massive balance sheet through bond tapering.
Economy Minister Minoru Kiuchi has warned that reducing bond holdings too quickly could create unnecessary market volatility, while government adviser Toshihiro Nagahama has argued that the administration places greater emphasis on quantitative monetary tools such as bond purchases than on conventional rate hikes.
BOJ resists calls to reverse course
For the BOJ, increasing bond purchases again would undermine years of efforts to exit extraordinary monetary stimulus.
The central bank scrapped its yield curve control policy in 2024 and has since been gradually reducing its bond holdings as part of its broader policy normalisation strategy.
BOJ officials maintain that bond purchases should only be used during exceptional periods of market stress and not as a routine tool to suppress government borrowing costs.
Last week, the central bank released research arguing that higher inflation—not the reduction in its bond purchases—has been the primary driver behind rising government bond yields.
Minutes from the BOJ’s June policy meeting also showed policymakers discussing the eventual size of the central bank’s balance sheet, signalling their commitment to continue unwinding years of aggressive monetary easing.
Markets are watching the BOJ’s credibility
Economists warn that if the BOJ resumes large-scale bond buying simply because of political pressure, investors could question its commitment to fighting inflation.
Former BOJ official Nobuyasu Atago warned that renewed bond purchases aimed at lowering yields could fuel concerns about “fiscal dominance,” where government financing needs begin influencing monetary policy decisions.
Such a perception, analysts say, could weaken confidence in the central bank’s independence.
Could the BOJ still intervene?
Despite its commitment to policy normalisation, the BOJ has left the door open for emergency intervention.
Officials have said the central bank could step into the bond market if yields rise too rapidly or disorderly enough to threaten financial stability rather than reflecting economic fundamentals.
According to people familiar with the BOJ’s thinking, the central bank is not targeting any specific yield level. However, if a sharp fall in demand for government bonds causes borrowing costs to spike suddenly, emergency bond purchases remain an option.
Analysts say the BOJ now finds itself balancing two difficult objectives—raising interest rates to contain inflation while ensuring that volatility in the world’s third-largest government bond market does not destabilise Japan’s financial system.
For now, the central bank’s path towards further rate hikes appears increasingly dependent not just on inflation and economic data, but also on whether Japan’s bond market remains calm enough to allow policymakers to continue normalising monetary policy.
