How far monetary normalization can go in Japan after today’s rate hike

The Bank of Japan raised its policy rate by 0.25ppts to 0.75% at its meeting on Friday, which the dovish government had to accept in face of yen weakening pressures. Although we still project another hike to a terminal rate of 1% in mid-2026, the BoJ could find it more difficult to justify this if inflation eases towards 2% in H1 2026 and pressure on the yen fades.

In the statement, the bank explained that the prospect of achieving the 2% inflation target has improved enough to justify rate normalization as uncertainties of the US economy and the impact of global trade policy have declined. It also noted that firms are highly likely to continue to raise wages steadily in 2026 given recent information.

We project core-core inflation will continue to decelerate, stabilising at 2% by mid-2026 as supply-driven food inflation gradually fades. A major risk is prolonged cost-push inflation due to additional supply shocks or yen depreciation. The yen could remain under pressure if fiscal concerns and the perception of an overly-dovish BoJ prevail over the impact of the yield gap.

We believe proactive fiscal policy will only have limited impact on the economic outlook and the BoJ’s rate decision. If fiscal policy starts to threaten the stability of the Japanese government bond market, then we expect that the BoJ would respond by flexibly adjusting the pace of quantitative tightening or by conducting a JGB purchase to contain market turbulence.