Yen Weakness and Inflation Overshoot: Is the BOJ Losing Control of Its 2% Target?

The Bank of Japan (BOJ) has long grappled with the challenge of achieving its 2% inflation target, a goal that has remained elusive for over a decade. In 2024, the central bank began a cautious shift away from its ultra-loose monetary policy, raising interest rates for the first time in years. However, recent developments-particularly persistent yen weakness and inflation overshooting the target-have raised questions about the BOJ's ability to maintain control over its economic trajectory. This analysis examines the interplay between central bank policy divergence, inflation risks, and the BOJ's evolving strategy, offering insights for investors navigating Japan's complex macroeconomic landscape.

Yen Weakness and Its Impact on Inflation

The yen's depreciation has emerged as a critical factor complicating the BOJ's inflation control efforts. Despite raising interest rates to 0.75% in late 2025-a 30-year high-the yen weakened against major currencies like the U.S. dollar and euro according to analysis. This divergence between tighter monetary policy and a weaker yen has fueled skepticism among traders about the BOJ's capacity to sustain further rate hikes. The yen's decline is partly attributed to global policy dynamics: while the BOJ has tightened, the U.S. Federal Reserve and European Central Bank have maintained accommodative or neutral stances, creating a crosscurrent that undermines the yen's value.

The depreciation has exacerbated imported inflation, particularly in energy and food prices, pushing Japan's core CPI to 3.0% year-on-year in October 2024-the highest in decades. While the BOJ acknowledges that wage growth (which surged 5.1% in spring 2024 labor negotiations) is a positive driver of inflation, it remains wary of the risks posed by a weaker yen. Governor Kazuo Ueda has emphasized the need for "careful monitoring" to avoid excessive tightening that could destabilize the economy.

Policy Divergence and Global Implications

The BOJ's tightening cycle has created a stark policy divergence with other major central banks. This divergence has triggered the unwinding of trillions in yen carry trades, where investors borrowed yen at low rates to fund higher-yielding assets in other currencies. The resulting volatility has pressured global markets, with Japanese government bond yields rising to 1.978% in December 2024-the highest since 2007. While the BOJ aims to normalize monetary policy, its cautious approach contrasts with the more aggressive tightening seen in the US and Europe, creating uncertainty for investors.

This divergence also highlights the BOJ's internal divisions. Meeting minutes from July 2024 revealed that board members were split on the pace of rate hikes: some advocated for gradual increases to avoid overshooting the inflation target, while others urged caution to temper market expectations. This lack of consensus has led to a fragmented policy signal, further complicating the BOJ's ability to anchor inflation expectations.

Fiscal Policy Conflicts and Inflation Risks

Compounding the BOJ's challenges is Japan's expansionary fiscal policy. The Ministry of Finance proposed a record 32.38 trillion yen in government bond expenditures for FY2026, part of a broader stimulus package aimed at offsetting a 2.3% annualized GDP contraction in Q3 2024. This fiscal expansion, combined with monetary tightening, has created a self-reinforcing cycle of rising debt-servicing costs and investor concerns about fiscal sustainability. With Japan's public debt already at 263% of GDP-the highest among major economies-this divergence between monetary and fiscal policy poses significant long-term risks.

The BOJ's efforts to normalize rates have also driven up borrowing costs for the government. The Ministry of Finance estimates that higher long-term interest rates will increase debt-servicing costs by 2.52 trillion yen. This fiscal strain could force the government to prioritize short-term stimulus over long-term debt management, further complicating the BOJ's inflation control objectives.

Political and External Risks

Political instability in Japan has added another layer of uncertainty. The Liberal Democratic Party's loss of an absolute majority in the October 2024 elections has raised questions about the continuity of fiscal and monetary policies. While Finance Minister Satsuki Katayama has publicly denied policy divergence with the BOJ, the political landscape remains fluid, with potential shifts in fiscal support for households amid ongoing inflationary pressures.

Externally, U.S. tariff policies and geopolitical tensions with China have introduced additional risks. The BOJ's internal discussions in June 2025 revealed that some board members advocated for a pause in rate hikes due to the economic uncertainty posed by U.S. trade policies. Meanwhile, tensions over Taiwan have disrupted bilateral economic cooperation, threatening to prolong Japan's economic stagnation.

Investment Implications

For investors, the BOJ's balancing act between inflation control and economic stability presents both risks and opportunities. The yen's weakness, driven by policy divergence and global market dynamics, suggests continued volatility in currency markets. Investors may consider hedging against yen depreciation or allocating to Japanese equities, which could benefit from wage growth and corporate investment.

However, the fiscal risks associated with Japan's expansionary policies cannot be ignored. Sovereign debt and government bond yields are likely to remain under pressure, making high-yield corporate bonds or inflation-linked assets more attractive. Additionally, geopolitical uncertainties and internal BOJ divisions warrant a cautious approach to long-term investments in Japan's real estate and public infrastructure sectors.

Conclusion

The BOJ's journey toward normalizing monetary policy is fraught with challenges. While inflation has exceeded the 2% target, the central bank's cautious approach and internal divisions have limited its ability to act decisively. The yen's weakness, fiscal policy conflicts, and external risks further complicate its path. For now, the BOJ appears to retain control of its inflation target, but the sustainability of this trajectory remains uncertain. Investors must remain vigilant, navigating the interplay of policy divergence, inflation risks, and geopolitical dynamics to position portfolios effectively in this evolving environment.