Bank of Japan lifts interest rates to 31-year high

The Bank of Japan raised interest rates to a 31-year high today and signalled its readiness to keep pushing up borrowing costs, joining other major central banks in fighting persistent inflation pressures driven by soaring oil costs.

But the widely expected move failed to prop up the yen, which instead fell as investors focused on a lack of explicitly hawkish guidance and two dovish dissenters who argued for patience in pushing up borrowing costs.

"The rate hike itself was in line with market expectations, but the two dissenting votes came as a modest surprise, as only some market participants had anticipated them," said Hirofumi Suzuki, chief FX strategist at SMBC in Tokyo.

"The outcome has somewhat tempered expectations for further rate hikes and conveyed a dovish impression."

At the two-day meeting ending on Friday, the Bank of Japan raised its policy rate to 1.25% from 1% by a 7-2 vote. Dovish board members Toichiro Asada and Ayano Sato dissented to the decision.

The move follows rate hikes by its European and US peers, highlighting central banks' focus on global inflation risks caused by the Iran war-induced energy cost spike, expansionary fiscal policies and surging demand for AI investment.

It was the first hike in three months and takes interest rates closer to levels the Bank of Japan deems neutral to the economy, marking another step away from decades of ultra-low rates that cemented the yen's status as a cheap global funding currency.

In a statement announcing the decision, the Bank of Japan said while economic and price developments are moving in line with its baseline forecast, there was a risk of underlying inflation deviating from its 2% target.

"Wholesale inflation remains elevated and price pressures from business-to-business trading has started to spill over into consumer prices," the Bank of Japan said.

"Underlying inflation has been approaching 2%" as companies continue to pass on the cost of higher wages and inflation expectations keep heightening, it said.

Markets are focusing on Bank of Japan Governor Kazuo Ueda's news conference for clues on the pace and timing of future rate hikes.

"The tone of the statement, along with two dissenters on the decision to raise rates, leaves lingering doubts that Japan's central bank will be cautious in tightening monetary policy further," said Fred Neumann, chief Asia economist at HSBC in Hong Kong.

"All eyes are now on the press conference to be held by Governor Ueda, with the market looking for hawkish reassurances that the Bank of Japan is prepared to raise rates again soon," he added.

The Bank of Japan exited a decade-long stimulus in 2024 and has raised rates several times, including in June, at a pace of roughly twice a year on the view Japan was making progress in durably achieving its 2% inflation target.

Today's hike to 1.25% brings the rate within the Bank of Japan's estimated 1.1% to 2.5% range of Japan's nominal neutral rate, or the level that neither cools nor overheats growth, raising questions about how far it could eventually hike rates.

But the Bank of Japan still lags global peers with its policy rate lower than that of the European Central Bank, which raised its key rate last week to 2.5%, and the Fed's 3.75%-4% range.

The slow pace of Bank of Japan rate hikes had been blamed for causing a weak yen that pushes up import costs and broader inflation.

Core consumer inflation held steady near the Bank of Japan's 2% target in August, data showed on Friday, as companies continued to pass on rising costs for a wide range of food and grocery items.

Analysts polled by Reuters expect the Bank of Japan to hike rates to 1.5% by the of end of March next year and then to 1.75% in the second quarter of 2027. Most saw the terminal rate as being at least 1.75%.

Markets had nearly fully priced in September rate hike after a slew of hawkish Bank of Japan signals, including its warning in July of the risk of an inflation overshoot from soaring fuel costs, rising import costs from a weak yen and strong AI demand.

US Treasury Secretary Scott Bessent also piled in, saying he voiced his strong support for "decisive" monetary steps to combat yen weakness in a meeting with Ueda this month, held on the sidelines of a G20 finance leaders' gathering.

In agreeing to join Japan's yen-buying intervention, Bessent also urged Prime Minister Sanae Takaichi's administration to avoid ramping up fiscal stimulus - a move running counter to the BOJ's efforts to rein in inflation, sources have told Reuters.

But many Bank of Japan officials, including Ueda, remain vague on the potential speed and degree of future rate hikes, arguing that much would depend on the inflation outlook and how the bank's past rate hikes could affect financial conditions.