Japan hikes interest rates for only second time in 17 years to shore up yen and tame inflation

US Federal Reserve and Bank of England expected to announce their interest rates decisions soon

Japan’s central bank has hiked interest rates for only the second time in almost 17 years as the country grapples with a weakening yen and rising inflation.

The Bank of Japan raised the cost of borrowing from 0.01 per cent to 0.25 per cent after a meeting that concluded with a 7-2 vote by its board on Wednesday.

The dominant market expectation was that the central bank would leave the interest rates unchanged. Instead, it raised its short-term policy interest rate to the highest level since 2008.

The previous interest rate hike, the first time since 2007, came in March.

A higher interest rate means businesses and households need to pay more on loans while consumers get more interest on their savings. Japan’s new interest rate, however, is still lower by global standards.

Japan’s policy shift came hours before the US Federal Reserve was set to announce its latest interest rate decision, likely to be a cut in September. An announcement was also expected from the Bank of England on Thursday.

Bank of Japan governor Kazuo Ueda said his country could tighten the policy again if conditions demanded it.

"If the economy and prices move in line with our projection, we will continue to raise interest rates," Mr Ueda said at a press briefing.

"In fact we haven’t changed much our projection from April. We don’t see 0.5 per cent as any key barrier when raising rates."

Japan’s “move sits uncomfortably with a poor run of economic data and lack of demand-driven inflation”, said Stefan Angrick, a senior economist at Moody’s Analytics.

The central bank also announced a plan to cut its bond purchases by half to about ¥3 tn ($19.6 bn) by the first quarter of 2026.

Japan has seen inflation soar in recent months, though at a slower pace than in the US.

The central bank has forecast the core inflation rate, excluding prices of fresh food, to reach 2.5 per cent by the end of this year and remain around 2 per cent for the 2025 and 2026 fiscal years.

The country suffered an economic slowdown in early 2023 with an annualised contraction of 2.9 per cent from January to March. At the same time consumer prices rose by 2.6 per cent in June compared to the same period last year.

“Despite sluggish consumer spending, monetary officials sent a decisive signal by raising interest rates and allowing for a more gradual balance sheet reduction," Fred Neumann, chief Asia economist at HSBC, said.

"Rising inflation expectations also open the path for ongoing monetary policy normalisation by the Bank of Japan. Barring major disruptions, it’s on course to tighten further, with another interest hike by the start of next year.”

The yen rallied as much as 0.8 per cent, a three-month high, immediately after the announcement but the gains were reversed in choppy trade.

The central bank had been under pressure from lawmakers to tighten policy to support the weakening yen and control inflation.

Japan’s currency has lost about a third of its value since 2021, tumbling to a 38-year low of 161 against the US dollar on 27 June. It was trading close to ¥100 to $1 only a few years ago.