Bank of Japan Raises Rates by 0.25%, Tightening Cycle Likely to Continue

The Bank of Japan on Friday lifted its benchmark interest rate by 0.25 percentage points to 0.75%, marking the highest level in three decades and signaling a cautious step toward what I call the return to “a world with interest rates”.

■A delicate balancing act
From an economic standpoint, the hike is a welcome measure to curb inflation and temper speculative excesses. But caution is needed around the speed of tightening – the BOJ ought to proceed at a pace that does not negatively impact financial markets. While Japan’s rates have turned positive in recent times, this is only in nominal terms; real policy rates remain negative. This has fueled not only an increase in overall prices over the past few years, but also rising asset prices. Prolonged low rates have additionally contributed to a weaker yen, which has driven imported inflation. On the other hand, the weak yen has boosted equity valuations due to expectations of higher earnings among exporting firms. Wealthier households, which have increased their investment in overseas assets in recent years, have also seen their yen-denominated returns rise. However, lower-income households, which tend not to invest in stocks or overseas assets due to a lack of resources, are bearing the full brunt of rising living costs. This trend is deepening social disparities. Real estate markets tell a similar story. Property prices in urban centers have surged, driven in part by speculative investment from foreign investors who are profiting from Japan’s cheap borrowing costs and currency weakness. Overseas investment funds have been able to take advantage of Japan’s low interest rates to borrow cheaply, while currency weakness has fostered a perception of land being undervalued. As a result, many funds have poured billions into Tokyo’s five central wards and other prime locations, generating profits for them but affordability challenges for ordinary residents. Thus, Japan faces not only rising overall prices but also the potential risk of an asset bubble. These problems, coupled with the government’s intention to pursue aggressive fiscal stimulus, strengthen the case for continued monetary tightening. Still, the pace ought to be moderate. A rapid series of hikes risks disrupting financial markets and a repeat of the 1990’s bubble collapse.

■A terminal rate of 1.5%
Our baseline scenario anticipates another 0.25-point increase in mid-2026, followed by annual hikes that would bring the policy rate to around 1.5% by early 2028. If we were to only consider the side effects of low rates, it might seem desirable to promptly aim for 2%, as this would make real rates positive. However, considering economic cyclicality and other factors, 1.5% is likely to mark the terminal point for this cycle. Additionally, should the Takaichi administration press ahead with large-scale spending, the BOJ may have little choice but to accelerate tightening. Fiscal policy trends are likely to significantly influence how quickly the BOJ raises rates.

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