Japan Prepares for Possible Bank of Japan Rate Hike Sooner and Larger Than Expected

Rising bond yields and persistent inflation boost expectations for an earlier and higher rate increase / Reuters

Japan is on the cusp of a shift in its monetary policy, with growing expectations that the Bank of Japan (BOJ) could raise interest rates sooner and more significantly than previously anticipated. Hawkish statements from the BOJ and stubborn inflation have driven bond yields to multi-year highs, challenging the long-standing assumption that rates would remain low in the country’s historically deflation-prone economy.

Mitsubishi UFJ Morgan Stanley Securities revised its forecast this week, now predicting the BOJ will increase interest rates to 0.75% by July, up from the current 0.5%. Previously, the financial group had expected this hike to occur in the latter half of the year, around October or December. Additionally, they now anticipate the BOJ will raise rates to 1.0% in January 2026, a shift from the prior forecast, which suggested this change would not happen until the end of the year. This adjustment comes in response to intensifying inflationary pressures, which analysts expect will persist throughout 2025.

Former BOJ official Nobuyasu Atago noted that the Bank of Japan’s growing focus on inflation risks could lead to a rate hike at the upcoming April 30-May 1 meeting. He remarked that the market is beginning to factor in the possibility of a rate increase sooner than expected, as Japanese bond yields have risen in recent weeks.

Bond yields have spiked as markets reassess their views on the BOJ’s future policy moves. Previously, there was an assumption that the central bank would not push rates beyond 1%, the lower bound of its estimated neutral rate range of 1% to 2.5%. However, with the benchmark 10-year Japanese government bond yield hitting its highest level since 2010 at 1.375%, and the five-year yield reaching 1.040%, levels not seen since 2008, investors are recalibrating their expectations. These sharp increases are reflective of a broader shift in market sentiment regarding future rate hikes.

Recent data has only strengthened the case for an impending rate hike. Strong GDP figures for the October-December period and persistent inflation in early 2025 have contributed to a rise in both the yen’s value and bond yields. The solid economic performance suggests that Japan may be on track to meet the BOJ's 2% inflation target, prompting market speculation that further rate hikes are imminent.

BOJ board member Hajime Takata’s speech and subsequent news conference later this week will be closely analyzed for insights into the timing and magnitude of any future rate increases. In January, the BOJ raised short-term rates to 0.5%, signaling its readiness to continue tightening monetary policy as the economy moves closer to its inflation goal.

A quarterly report published by the BOJ on January 24 highlighted the role of persistent labor shortages in fueling wage-driven inflation. This development adds weight to the argument for further rate hikes, as rising wages and increased consumer spending put upward pressure on prices. On the heels of this report, BOJ Deputy Governor Ryozo Himino remarked that Japan’s real interest rates, which have been negative for an extended period, should not remain so for much longer. Board member Naoki Tamura echoed these sentiments, calling for a minimum rate increase to 1% by early 2026.

As the BOJ’s hawkish stance gains momentum, markets are pricing in an 80% chance of a rate hike to 0.75% in July. A private-sector survey conducted earlier this month indicated that most economists expect this adjustment to occur later in 2025, with the timing of the next rate increase likely to come in the second half of the year.

Makoto Sakurai, a former BOJ board member who remains well-connected with current policymakers, predicts that the BOJ will raise rates to at least 1.5% over the next two years. The International Monetary Fund (IMF) has similarly projected that Japan's neutral rate is likely to fall within the 1% to 2% range, with a midpoint of 1.5%. Based on this, the IMF anticipates that the BOJ will likely raise rates to this level by the end of 2027.

One external factor that may influence the BOJ’s decision-making process is U.S. President Donald Trump's policies, particularly his focus on addressing trade imbalances. Some analysts believe these efforts could indirectly support the BOJ’s rate hikes by diminishing Japan’s resistance to a stronger yen and, by extension, higher interest rates. U.S. Treasury Secretary Scott Bessent recently indicated that Washington would scrutinize whether foreign governments are manipulating their currencies, which could lead to reciprocal tariffs.

Given these circumstances, Naomi Muguruma, chief bond strategist at Mitsubishi UFJ Morgan Stanley Securities, suggested that the Japanese government is keenly aware of the political risks of leaving the yen too weak, especially in the context of Washington's growing pressure on currency policy. As the BOJ prepares to raise rates in the near term, the shifting dynamics of both domestic economic indicators and international pressures will likely play a significant role in shaping Japan’s monetary policy outlook for the coming months.