The Bank of Japan is widely expected to lift its policy rate from 1% to 1.25% at the conclusion of its two-day meeting on Friday, marking the highest level in 31 years. This would represent the first increase in three months and another decisive step in its ongoing departure from decades of ultra-low interest rates.

The move aligns with the European Central Bank's recent tightening and mirrors the expected policy action from the US Federal Reserve this week, underscoring a shared focus among major central banks on inflation risks. Markets have already largely priced in the hike, shifting attention to Governor Kazuo Ueda's post-meeting press conference for any signals on the timing and pace of future increases.

Rate Hike Expectations: 1.25% and a 31-Year High

The Bank of Japan will raise its policy rate from 1% to 1.25% at Friday's monetary policy meeting. This marks the first hike in three months and brings rates closer to the level the central bank views as broadly neutral for the economy. The move signals Japan's accelerated exit from its decades-long era of ultra-low interest rates—a period that cemented the yen's status as the world's primary cheap funding currency and underpinned extensive carry trades.

Looking back, the BOJ has implemented multiple rate increases since formally exiting its massive decade-long stimulus program in 2024, including one in June. While the July meeting kept rates unchanged, it issued explicit warnings that surging oil prices, persistent yen weakness driving up import costs, and robust AI-related demand could all pose upside risks to inflation.

Earlier this month, Ueda stated publicly that underlying inflation is "quite close" to the 2% target and that the central bank must pay particular attention to upside inflation risks. Markets widely view this hike as a critical step in the policy normalization process, reflecting a structural shift in Japan's economic and inflationary environment.

Pressure from Washington

The US government has voiced clear support for Japan's continued rate hike cycle. Washington's position is driven by its own considerations: a weak yen could force Japan to sell dollar-denominated assets, including US Treasuries, to support its currency, thereby pushing up US bond yields—something Washington wants to avoid. Consequently, the US favors a stronger yen.

US Treasury Secretary Scott Bessent urged BOJ Governor Ueda to take "decisive market and monetary policy measures" at the G20 finance ministers and central bank governors meeting earlier this month. This statement is seen as direct US pressure on Japan's monetary policy and reflects the Trump administration's ongoing focus on yen exchange rate issues. In fact, the two nations conducted a historic joint intervention in late July to bolster the yen.

Takahide Kiuchi, executive economist at Nomura Research Institute and former BOJ policy board member, commented: "The Trump administration has effectively curtailed any potential moves by the Ishiba administration to prevent the BOJ from raising rates. Therefore, the BOJ has been given a free hand to proceed with hikes."

Meanwhile, recent hawkish remarks from BOJ policy board members have opened the door for accelerated tightening. With external pressure from Washington and internal hawkish groundwork from board members converging, the central bank's policy space is being redefined, making the path to further hikes smoother than before.

Market Focus: Ueda's Communication Challenge

With markets having almost fully priced in the rate increase, traders are quickly turning their attention to Ueda's wording and tone at the post-meeting press conference. A senior strategist at a major institution noted clear divisions within the market: one camp believes hawkish communication from the BOJ would help lower bond yields by easing concerns that the central bank is "behind the curve" on inflation; another argues that hawkish language would push yields higher by boosting bets on the terminal rate. Given the high uncertainty around market reactions, the strategist suggested the BOJ's best approach would be to remain as ambiguous and cautious as possible.

Ueda's core challenge lies in balancing competing objectives: the central bank wants to avoid pre-committing to an early next hike to preserve policy flexibility, but simply repeating its previous dovish "data-dependent" wording could trigger another round of yen selling, further elevating import prices and intensifying inflationary pressures. Conversely, overly hawkish language could destabilize an already fragile bond market—which has recently faced selling pressure due to concerns about Japan's fiscal situation, pushing yields to near three-decade highs. Every word from Ueda will walk a delicate line between the yen and the bond market.

Internal Divisions and the Size of the Move: 25 Basis Points Rather Than More

Board members who dissented at the June meeting may cast dissenting votes again. Given the need to assess the impact of past hikes on financial conditions, many within the BOJ may prefer a 25-basis-point increase rather than a larger move. According to a survey by a major institution, analysts expect the BOJ to raise rates to 1.25% this month, 1.5% by the end of March next year, and 1.75% by the second quarter of 2027.

Raising rates to 1.25% would push the BOJ's policy rate into its estimated nominal neutral rate range of 1.1% to 2.5%—the level that neither cools nor overheats growth—raising questions about how much further it can ultimately go. Ueda has said the BOJ has no preconceived ideas about the size of hikes, but according to sources familiar with the matter, many within the central bank may believe there is room for several more increases before reaching the neutral rate. Hawkish board members see the neutral rate around 2%. One source indicated that postponing necessary hikes would create side effects, though the pace would depend on economic, price, and financial conditions at the time.

Fiscal Policy Complexity: Ishiba's Expansionary Spending and IMF Warnings

Prime Minister Shinzo Ishiba's expansionary fiscal policies add further complexity to the BOJ's decision-making. The International Monetary Fund's managing director recently warned that unprecedented large-scale fiscal support deployed by governments is posing significant challenges for central banks worldwide. In a speech last week, she emphasized that high levels of public debt combined with concerns about "fiscal dominance" are jointly elevating the risk of upside inflation expectations.

In this context, central banks will need to respond more forcefully and decisively to potential future shocks to protect their independence, maintain policy credibility, and effectively fulfill their core mandate of price stability. Ishiba's fiscal expansion aims to stimulate growth and counter external shocks, but it may also offset the effects of monetary tightening and increase inflation stickiness. This requires the BOJ to carefully assess fiscal-monetary policy coordination as it advances rate hikes, avoiding conflicting policy objectives that could undermine overall macro stability.

Two Hurdles on the Yen's Appreciation Path

The dollar-yen pair is poised for a third consecutive day of gains, hitting a high of 155.48—the strongest since September 8—and currently trading around 155.20. However, the yen's downside is not without constraints, as policy support is accumulating. A senior macro strategist at a major institution recently stated that the BOJ's recent hawkish shift would provide significant support for the yen, helping maintain the exchange rate in a relatively strong zone around the 160 level.

The strategist noted that as the central bank continues policy normalization and signals firmer tightening intentions, bearish sentiment toward the yen is likely to ease somewhat, limiting the dollar-yen's further upside potential. However, he also emphasized that a substantial yen breakout above the 150 level "won't be easy." On one hand, excessively rapid currency appreciation could hurt Japan's export-oriented companies and erode their international competitiveness; on the other hand, government and business officials remain highly vigilant against "inappropriately" rapid appreciation. Should the exchange rate show signs of sharp strengthening, authorities may respond through verbal intervention, policy signals, or even concrete actions.

Therefore, even if the BOJ maintains its hawkish stance, the yen's appreciation path will remain constrained by both policy and market forces, and it is more likely to fluctuate within a limited range in the near term rather than strengthen unilaterally. A survey showed that approximately 61% of respondents expect the dollar-yen to trade between 155 and 160 over the next month. Analysts say the BOJ's hawkish turn will help keep the yen above the 160 level, but a rise past 150 "won't be easy" given that government and business officials will oppose "inappropriately" rapid currency appreciation.

As of 13:54 Beijing time, the dollar-yen traded at 155.18/19.