Bank of Japan is poised to raise rates to a 30-year high despite economic weakness

The Bank of Japan (BOJ) commenced its final policy meeting of the year on Thursday, with widespread anticipation of an interest rate hike. Such a move would elevate the benchmark rate to its highest point in 30 years, continuing the policy normalization efforts initiated last year.

The decision, slated for Friday, could see rates climb to 0.75%, a level unseen since 1995. Data from LSEG indicates an 86.4% probability of the BOJ implementing this increase.

A rate hike is likely to bolster the yen's value against the dollar and help curb inflation, which has exceeded the BOJ's target for 43 consecutive months. That said, the reality is a bit more complicated. it also carries the risk of further dampening Japan's already fragile economy, which experienced contraction in the third quarter.

Revised GDP figures revealed a greater-than-initially-estimated contraction in the Japanese economy for the three months ending in September. The economy shrank by 0.6% compared to the previous quarter, or 2.3% on an annualized basis.

With a rate hike largely priced in, market focus will likely center on the BOJ's accompanying commentary, according to experts. Gregor MA Hirt, global multi-asset chief investment officer at Allianz Global Investors, suggested in a note that the market's reaction will hinge on the nuances of the BOJ's communication.

Specifically, investors will be scrutinizing signals regarding the neutral, or terminal, rate—the rate that balances inflation and economic growth—as well as any remarks concerning the yen's weakness.

Earlier this month, Governor Kazuo Ueda reportedly acknowledged the difficulty in estimating the terminal rate, with the central bank placing it in a range of 1% to 2.5%. Ueda told Japan's parliament that the neutral rate of interest is a concept for which they can only produce an estimate with quite a wide range.

Carl Ang, a fixed income research analyst at MFS Investment Management, anticipates that an updated estimate of the neutral rate might be shared following the Friday meeting.

Japan initiated its policy normalization last year, moving away from the negative interest rate regime, the world's only one, that had been in place since 2016. Since then, the BOJ has maintained a consistent stance of gradually raising rates.

Investors will be closely monitoring the BOJ's commentary regarding the pace of future rate hikes. ING, a Dutch bank, suggested in a note that while the market largely anticipates another hike in June 2026, the BOJ is more likely to wait until October for the next increase. Bank of America, on the other hand, forecasts a hike in June but doesn't rule out an earlier move in April if the yen experiences rapid weakening. BofA analysts expect the BOJ to bring the terminal rate to 1.5% by the end of 2027.

While MFS' Ang noted potential risks to Japan's policy normalization path, including a U.S. economic slowdown and escalating tensions between China and Japan, he believes it would take a "material shock" to significantly alter the BOJ's rate trajectory.

Higher rates will also increase bond yields and borrowing costs for the Japanese government, which has implemented its largest stimulus package since the Covid-19 pandemic in an attempt to stimulate the economy.

Nikkei reported earlier this month that Japan's borrowing costs could double if benchmark yields rise to 2.5% from their current level of around 2%. Yields on 10-year Japanese government bonds are currently near 18-year highs, last recorded at 1.971%.

A yield of 2.5% would translate to interest payments for the Japanese government jumping to 16.1 trillion yen in fiscal year 2028, compared to 7.9 trillion yen in fiscal year 2024.

Taking into account fiscal concerns and potential intervention by the finance ministry in forex markets, something that Finance Minister Satsuki Katayama has not dismissed, MFS' Ang anticipates the yen to remain between 150 and 160 next year.