The Bank of Japan announced on Wednesday a 25 basis point increase in its benchmark interest rate to 1%, marking the highest level since 1995. It also declared that it will suspend the reduction of its government bond purchases starting from April 2027. Both decisions were approved by a 7-1 vote.
This rate hike was in line with market expectations. In its statement, the central bank cautioned about the risk of core CPI inflation overshooting its price target, noting that the year-on-year CPI increase could accelerate to levels significantly above 2%. It specifically highlighted that the pass-through of rising crude oil prices is proceeding at a "relatively fast pace" and may spread, pushing up consumer prices for a wide range of goods and services. The bank also stated it would continue raising the policy rate based on developments in economic activity, prices, and financial conditions.
Regarding its bond purchase reduction plan, the central bank announced that from April 2027, it will maintain its monthly government bond purchases at around 2 trillion yen, halting any further reduction, and will discontinue its previous mid-term review practice. This move signifies that while maintaining its interest rate hike trajectory, the bank is applying the brakes on the pace of quantitative tightening, creating a degree of internal balance in its policy approach.
Following the Bank of Japan's rate hike, the Nikkei 225 index rose over 0.5%, hitting a new all-time high. The Topix index recovered its losses, turning flat for the session.
Inflation Risks Drive Rate Hike Decision
The Bank of Japan provided the core rationale for the rate increase in its statement: the Japanese economy is generally in line with the baseline forecast scenario, the mechanism of moderate wage and price increases is expected to be sustained, and core CPI inflation is projected to rise gradually, reaching a level consistent with the price stability target between the second half of fiscal 2026 and fiscal 2027.
The bank noted that Japan's economy is recovering moderately. While some areas remain weak, the risk of a severe economic slowdown has decreased compared to the previous period, and the economy is expected to continue growing modestly. Financial conditions remain accommodative, with real interest rates staying negative, primarily in the short- to medium-term segments.
The central bank stated that even after adjusting the policy rate, accommodative financial conditions will persist, continuing to firmly support economic activity.
Halting Bond-Buying Cuts to Preserve Flexibility
The existing plan for reducing bond purchases remains unchanged until the January-March quarter of 2027, with a quarterly reduction of 200 billion yen per month. From April 2027, the purchase scale will stabilize at approximately 2 trillion yen per month, with no further cuts.
Board member Naoki Tamura proposed continuing to reduce purchases by 200 billion yen per quarter from April 2027, but this proposal was voted down by the majority.
The bank also stated it would respond nimbly, including by increasing bond purchases and conducting fixed-rate purchase operations, should long-term interest rates rise rapidly. According to the bank's calculations, its holdings of Japanese government bonds are projected to decrease by about 36% to 39% by March 2030 compared to June 2024.
External Risks Pose Primary Uncertainty
Despite the generally manageable domestic inflation path, the Bank of Japan's statement placed significant emphasis on external risk factors.
The bank stated that at present, special attention must be paid to the potential impact of developments in the Middle East situation on financial markets, foreign exchange markets, the economy, and prices. It also stressed the need to closely monitor the effects of global AI-related demand and future exchange rate movements on Japan's economy and prices.
Regarding its forward guidance on policy, the bank indicated it will assess the probability of achieving the baseline forecast scenario and potential risks when considering the timing and pace of policy adjustments, maintaining its consistent data-dependent stance in the wording.
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