BOJ Set to Hike Rates to 0.75% as Inflation Pressures Mount

The Bank of Japan is set to raise its key policy rate to 0.75% from 0.50% at its December 18-19 board meeting according to reports. The move marks the central bank's first rate hike since January and its highest policy rate since 1995. This decision reflects growing concerns over inflation and a weaker yen, which have pushed import costs higher and fueled domestic inflation.

Economists are nearly unanimous in predicting the rate hike, with 90% of those surveyed by Reuters expecting the change at next week's meeting. The Tankan business sentiment survey, scheduled for release on Monday, will play a key role in confirming the central bank's stance. Recent data shows firms have become more willing to raise wages, which could help offset inflationary pressures.

Prime Minister Sanae Takaichi has not voiced opposition to the hike, despite concerns over Japan's fiscal outlook and high public debt. However, the government has also signaled a willingness to tolerate rate increases, given the risks of inflation and the yen's weakness.

Why the Standoff Happened

The BOJ's decision is driven by prolonged inflation, which has exceeded its 2% target for over three years. A weak yen has exacerbated the problem, making imports more expensive and contributing to rising consumer prices. Governor Kazuo Ueda has emphasized the need to normalize monetary policy after decades of ultra-loose measures. At the same time, wage growth has picked up, with nominal wages rising 2.6% year-on-year in October. This suggests a shift in labor market dynamics that could help reduce the real burden of inflation.

The central bank is also cautious about how quickly to raise rates. While the rate is expected to reach 1% by September 2026, the pace of hikes will depend on the economic response to each increase.

The BOJ is likely to avoid using the neutral rate as a primary tool for communication, citing the difficulty of estimating it accurately.

How Markets Reacted

The Japanese yen has been under pressure in recent weeks as investors priced in the likelihood of a rate hike. Despite the hawkish stance of the BOJ, the yen remains weak against the U.S. dollar, with the USD/JPY pair hovering near 155.00. The weak yen has been a double-edged sword for Japan, supporting exports while increasing inflationary pressures.

Foreign investors have also been selling Japanese long-term bonds ahead of the expected rate hike. The benchmark 10-year government bond yield has approached 2%, its highest level in more than 17 years. This reflects growing concerns about Japan's fiscal health and the potential for further inflationary shocks.

Domestically, the Nikkei stock index has struggled to gain momentum, with investors waiting for clarity on the BOJ's next steps. The government's recent stimulus package has raised concerns about public finances, further complicating the BOJ's policy choices.

What Analysts Are Watching

Analysts are closely watching the BOJ's December meeting for clues about the pace and magnitude of future rate hikes. While the central bank is expected to raise rates to 0.75%, market participants are more interested in how it communicates the next steps. A clear signal from the BOJ could influence the path of the yen and broader financial markets. Investors are also keeping an eye on the U.S. Federal Reserve's next moves. The Fed is expected to cut rates again this week, deepening the divergence between U.S. and Japanese monetary policies. This contrast could continue to support the yen in the short term, despite its weak fundamentals.

In the long run, the BOJ must balance the need to control inflation with the risks of tightening too aggressively in a fragile economy. With real interest rates still deeply negative and economic growth slowing, the central bank faces a difficult balancing act according to market analysis. The market will be watching closely to see whether the BOJ can navigate this challenge without triggering a sharper slowdown.