Japan’s central bank is preparing to cap the year with one of its most consequential policy decisions in a generation, as investors brace for a rate hike that would take borrowing costs to levels not seen since the mid-1990s and accelerate the country’s long-delayed exit from ultra-loose monetary policy.
The Bank of Japan began its final policy meeting of the year on Thursday, with a decision due on Friday. Markets have largely priced in a hike, with LSEG data showing an 86.4% probability that the benchmark rate will be raised to 0.75%, the highest since 1995. The move would reinforce the normalization path the BOJ laid out last year after scrapping its negative interest rate regime, which had been in place since 2016.
The case for tightening has been built on stubborn inflation. Consumer prices have remained above the BOJ’s 2% target for 43 consecutive months, eroding purchasing power and keeping pressure on policymakers to act. A rate increase would also be expected to support the yen, which has been under sustained pressure against the dollar, and help contain imported inflation.
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Yet the decision comes at a delicate moment for the broader economy. Revised GDP figures showed that Japan’s economy contracted more sharply than initially thought in the third quarter, shrinking 0.6% quarter on quarter and 2.3% on an annualized basis in the three months through September. That weakness has raised concerns that higher borrowing costs could further slow growth just as the government rolls out fresh stimulus to revive demand.
With a hike widely anticipated, attention has shifted to the BOJ’s messaging. Investors are expected to parse Governor Kazuo Ueda’s comments for clues on how far rates could ultimately rise and how quickly future moves might come. The so-called neutral or terminal rate — the level that neither stimulates nor restrains the economy — remains a key unknown.
Ueda has previously acknowledged the uncertainty. Earlier this month, he told Japan’s parliament that the central bank estimates the neutral rate to lie somewhere between 1% and 2.5%, a wide range that underscores the difficulty of guiding policy with precision.
“Unfortunately, the neutral rate of interest is a concept for which we can only produce an estimate with quite a wide range,” Ueda said, adding that policymakers must continue to operate without full clarity on that benchmark.
Carl Ang, fixed income research analyst at MFS Investment Management, said markets may gain further insight after Friday’s meeting, possibly through updated projections or more detailed guidance on the BOJ’s longer-term thinking.
The pace of future hikes remains a point of debate. ING said this week that while markets are leaning toward another increase in June 2026, it sees October as a more likely timing. Bank of America, by contrast, expects a June hike and does not rule out an earlier move in April if the yen weakens rapidly, projecting the terminal rate to reach about 1.5% by the end of 2027.
Political dynamics are also in focus. Prime Minister Sanae Takaichi, who took office in October, had during her leadership contest staunchly opposed BOJ rate hikes, arguing that premature tightening could derail the recovery. Since assuming office, however, she has softened that stance, signaling a more pragmatic approach as inflation proves more persistent and currency pressures intensify.
The shift has eased some concerns about friction between the government and the central bank as normalization proceeds.
Higher rates carry clear fiscal implications. Rising borrowing costs will push up bond yields and increase debt-servicing expenses for the Japanese government, which has already unveiled its largest stimulus package since the Covid-19 pandemic in an effort to shore up the economy. Japan’s debt burden remains among the highest in the developed world, making the trajectory of yields a sensitive issue.
Nikkei reported earlier this month that Japan’s borrowing costs could double if benchmark yields climb to 2.5% from around 2% currently. Yields on 10-year Japanese government bonds are already hovering near 18-year highs, last trading at about 1.971%. Should yields reach 2.5%, interest payments by the government would rise sharply, jumping to an estimated 16.1 trillion yen in fiscal 2028 from 7.9 trillion yen in fiscal 2024, according to the report.
Currency markets remain another source of uncertainty. The yen has traded in a weak range of roughly 154 to 157 per dollar since November, and has fallen more than 2.5% since Takaichi took office. While the BOJ has largely avoided direct commentary on the exchange rate, any explicit remarks from Ueda could be interpreted by markets as a signal of discomfort with further yen weakness.
Ang noted that fiscal concerns and the possibility of intervention by the finance ministry — something Finance Minister Satsuki Katayama has not ruled out — could temper the currency’s response to higher rates. Taking those factors into account, he expects the yen to trade in a range of 150 to 160 against the dollar next year, even as policy tightening continues.