What happened?
At its Monetary Policy Meeting held on September 17-18, the Bank of Japan (BOJ) raised its policy rate from 1.00% to 1.25%. As many major Japanese media outlets had reported in advance that the BOJ intended to raise rates at this meeting, the move was largely priced into financial markets. The BOJ's rationale for further tightening shifted at its July meeting. Previously, it had justified rate hikes on the grounds that the policy rate remained significantly below the neutral rate. In July, however, the BOJ changed its emphasis, arguing that policy tightening was needed to address the risk that underlying inflation could overshoot its 2% target. The same logic was reiterated in this meeting's decision.
In its policy statement, the BOJ maintained that financial conditions remain accommodative and signaled its intention to continue raising rates going forward. However, financial markets are now focused less on whether the BOJ will continue tightening and more on the pace at which future rate hikes will be delivered.
How have markets reacted?
Japan's 10-year government bond yield rose only modestly, from 2.94% immediately before the BOJ announcement to 2.97% as of the time of writing (4:00 pm JST on November 18). Given that the rate hike had already been largely priced in, the muted market reaction was unsurprising.
In the foreign exchange market, the yen had already come under pressure after the FOMC raised rates two days earlier. That trend continued following the BOJ decision, with the dollar-yen exchange rate moving from USD156.0 per U.S. dollar on the previous day to USD157.5 at the time of writing. The weaker yen likely reflected some disappointment among investors that the BOJ's statement did not signal an acceleration in the pace of future rate hikes.
Equity markets reacted more positively. Supported by gains in US equities the previous day, the Nikkei225 had already been higher during the morning session. After the BOJ announcement, further yen depreciation provided an additional boost to exporters, helping the Nikkei rise 1.38% from the previous day's close.
What is our outlook on the situation?
The BOJ has two meetings remaining this year, on October 29-30 and December 17-18. I believe there is a high probability that the BOJ will deliver another rate hike to 1.50% at its December meeting for four reasons. First, inflation risks remain tilted to the upside. Headline CPI inflation slowed to 1.9% YoY in August, but rising energy prices and the pass-through effects of yen depreciation are expected to push inflation back into the upper 2% range during Q1 2027. As household and corporate inflation expectations rise, the risk of underlying inflation exceeding the targeted 2% will increase.
Second, the Federal Reserve's more hawkish stance has heightened downside risks for the yen. This week's FOMC delivered a rate hike and signaled additional tightening later this year. If the BOJ delays further rate increases, widening interest-rate differentials between Japan and the US could accelerate yen depreciation and add to inflationary pressures.
Third, pressure from the US government is likely to continue. US policymakers appear concerned that excessive yen weakness could push Japanese long-term interest rates higher and, in turn, place upward pressure on US Treasury yields. Treasury Secretary Scott Bessent is believed to be encouraging the Japanese government not to constrain the BOJ's tightening efforts, suggesting that conditions remain favorable for additional rate hikes.
Fourth, the economic impact of the BOJ's tightening cycle has so far been limited. Recent Tankan survey results indicate that corporate financing conditions have remained largely stable despite the BOJ's consecutive rate increases.
Looking further ahead, I expect the BOJ to raise rates again in March and July 2027, bringing the policy rate to 2.00%, at which point the tightening cycle is likely to end. By mid-2027, the inflationary impact of higher oil prices and yen depreciation should have largely faded. In addition, a reduction in the consumption tax on food from 8% to 1%, scheduled to take effect in April 2027, is expected to ease inflation risks. As a result, the current tightening cycle is likely to conclude around the middle of 2027, in my view.
What is our resulting investment view?
The BOJ's policy normalization process appears to be entering its final stages. Importantly, this reflects Japan's successful and healthy exit from deflation rather than an overheating economy, suggesting that the negative growth impact of higher interest rates should remain limited. Corporate earnings have improved substantially as Japanese firms have adopted more proactive pricing strategies. More recently, real wages per worker have turned sustainably positive, supporting the prospect of continued growth in private consumption. At the same time, persistent labor shortages and the Takaichi administration's investment incentives for strategic industries are expected to keep capital expenditure on a solid upward trend. The anticipated medium-term expansion of domestic demand should therefore be supportive for Japanese equities. While higher interest rates are likely to weigh on sectors with relatively high borrowing dependence, such as real estate, they should benefit financial institutions and the broader financial sector.
Meanwhile, Japanese 10-year government bond yields have risen to around 3%, attracting greater attention from both domestic and international investors. The fiscal implications of the Takaichi administration's temporary food-tax reduction program (April 2027 to March 2029), planned income-support payments for low- and middle-income households beginning from April 2029, and spending programs targeting 17 strategic sectors appear to be largely priced into markets already. Should oil prices decline from current levels, the attractiveness of Japanese long-term government bonds could increase further.
What are the risks?
The first key risk is further yen depreciation. If future BOJ communications suggest a slower pace of rate hikes, or if inflation data significantly exceed market expectations, downward pressure on the yen could intensify. Such developments would likely push long-term interest rates higher as well. The second risk is fiscal deterioration. If the scale of the Takaichi administration's tax-cut and spending programs expands beyond current expectations, or if concerns emerge regarding their financing, Japanese financial markets could experience increased volatility in the form of higher long-term interest rates, a weaker yen, and lower equity prices. The third risk relates to energy supply disruptions stemming from worsening geopolitical tensions in the Middle East. Japan's energy imports have largely recovered to pre-Iran conflict levels, but damage to regional energy infrastructure or renewed supply disruptions could push energy prices significantly higher, resulting in stronger-than-expected inflationary pressure in Japan.
Investment risks
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested. Past performance is not a guide to future returns.
