Bank of Japan raises short-term interest rates to the highest level in 30 years

Japan’s central bank on Friday raised short-term interest rates to the highest level in 30 years, encouraging selling in government bonds and signaling it is prepared to tighten further as it normalizes policy.

The Bank of Japan raised its benchmark interest rate by 25 basis points to 0.75%, the highest level since 1995, in line with forecasts from economists polled by Reuters.

The Bank of Japan expects real interest rates to remain “significantly negative,” adding that accommodative financial conditions will continue to firmly support economic activity.

As a result of this decision, the 10-year Treasury yield rose by about 5 basis points to 2.019%, and the 20-year Treasury yield rose 3 basis points to 2.975%, both the highest levels since 1999.

The yen fell 0.25% against the dollar to 155.92 yen, while the benchmark Nikkei 225 stock index rose 1.28%.

Last year, Japan abolished the world’s only negative interest rate system, which had been in place since 2016, and began normalizing its policy. Since then, the Bank of Japan has consistently maintained its stance of gradually raising interest rates, stating that its goal is to create a “virtuous cycle” of rising wages and prices.

Inflation has exceeded the Bank of Japan’s 2% target for 44 consecutive months, with consumer prices rising 2.9% in November, data released today showed. Rising inflation is weighing on real wages, which have declined for 10 straight months, according to Labor Department data.

The Bank of Japan predicted that core inflation, which excludes fresh food prices, is likely to slow to below 2% from April to September 2026 due to slower food price increases and the effectiveness of government policies aimed at combating price increases.

Rising interest rates risk further exacerbating the slump in Japan’s economy. Revised GDP figures for the third quarter showed the economy contracted more than originally expected, contracting by 0.6% sequentially or 2.3% on an annualized basis.

The Bank of Japan said in a statement that despite signs of weakness in the economy, corporate profits are likely to remain high and companies are expected to continue raising wages in 2026.

“The mechanism in which both wages and prices rise slowly is likely to be maintained,” the central bank said, indicating that it is increasingly likely that underlying inflation will reach its 2% target.

The rate hike also comes as government bond yields have reached their highest level in decades and have risen sharply since the decision, raising the risk that Japan’s borrowing costs will rise and the fiscal burden increases.

Asia’s second-largest economy already has the world’s highest debt-to-GDP ratio, at around 230%, according to International Monetary Fund data.

However, rising yields could support the Japanese currency. The yen has been hovering around 154-157 yen against the dollar since November, and has depreciated by more than 2.5% since Prime Minister Sanae Takaichi, who supports monetary easing policy, took office in October.

Shigeto Nagai, head of Japan economics at Oxford Economics, said in a statement to CNBC before the BOJ’s decision that after the latest rate hike, the BOJ is likely to raise interest rates in mid-2026, bringing the final rate to 1%.

A terminal or neutral interest rate refers to an interest rate that balances inflation and economic growth, without overheating or slowing down the economy.

According to Reuters, Bank of Japan Governor Kazuo Ueda said at a press conference after the rate decision, “If necessary, we will seek a new estimate of Japan’s neutral interest rate, but I don’t think it will help narrow the range that much.”

Ueda reportedly said earlier this month that it was difficult to estimate the final interest rate because the central bank had fixed it at 1-2.5%.

“Looking to the future, the Bank of Japan is likely to continue raising interest rates in stages without providing a clear outlook for final interest rates,” Hirofumi Suzuki, chief foreign exchange strategist at Sumitomo Mitsui Banking Corporation, said in a note after the press conference.

Suzuki added that no rapid tightening is expected and downward pressure on the yen will continue.

Oxford University’s Nagai warned that further interest rate hikes by the Bank of Japan could cause friction with Takaichi if the inflation rate falls steadily towards 2% in the first half of 2026.

Takaichi firmly opposed the Bank of Japan’s interest rate hike during the leadership election, but has since softened his stance.

Mr. Nagai said that the reason Mr. Takaichi is allowing the latest interest rate hike is because of the weaker yen, and that “responding to the cost of living crisis has become an urgent policy issue.”

Takaichi has sought to shore up Japan’s slowing economy and provide support to inflation-hit consumers, with Japan’s cabinet approving a stimulus package totaling 21.3 trillion yen ($135.5 billion) in November.