Bank of Japan raises interest rates to highest level in 17 years

Stronger wages have contributed to the decision by Japan’s central bank to raise rates to about 0.5%. The BOJ reiterated that it may in the future raise interest rates again, if required.

The Bank of Japan (BOJ) raised its key interest rate to about 0.5% from 0.25% on Friday, noting that inflation is holding at a desirable target level.

“The economy is gradually recovering,” BOJ Governor Kazuo Ueda told reporters after a two-day policy board meeting in Tokyo.

He acknowledged uncertainties remain, including overseas inflation and foreign exchange fluctuations. But he reaffirmed his view that additional hikes will be needed if economic conditions endure.

“Our basic thinking has not changed,” he added, stressing the importance of “the positive cycle” of higher prices and wages.

Recent price data show inflation hovering at about the central bank’s 2% target. Government data released hours before the decision showed consumer prices, excluding volatile food prices, rose last year at an average rate of 2.5%, marking the third straight year of increase.

The consumer price index (CPI), excluding food, for the month of December alone showed a 3% rise.

Another long-term concern was wage growth. Recent data show Japanese workers are gaining better wages and are generally set to receive solid pay raises in their upcoming annual union negotiations.

The labour ministry adjusted its wage data for November to a rise of 0.5%, instead of a decline, helping to support the Bank of Japan’s decision.

Share prices fell immediately after the announcement, but the benchmark Nikkei 225 recovered shortly afterwards and ended little changed.

The U.S. dollar fell to 155.41 Japanese yen from about 156 yen earlier in the day.

A rate rise in July last year sent stock prices tumbling. The bank is also watching for market reactions to the policies of U.S. President Donald Trump.

Ueda said that the responses to the rate hike were muted, suggesting the central bank’s decision was on target.

The Bank of Japan increased the rate for the first time in 17 years in March last year, ending its negative interest rate policy, which amounts to negative borrowing rates.

Japan’s long-time ultra-lax monetary policy was meant to pull the economy out of deflationary tendencies and boost growth.

Deflation stagnates growth, as companies invest less, cut back on wages and people hold back on spending.

Japan’s stance is at odds with the loosening trends adopted by the U.S. Federal Reserve and the European Central Bank, which have been cutting rates after raising them to clamp down on inflation.

The Fed indicated recently it will slow the pace of rate cuts.

Dilin Wu, a research strategist at Pepperstone, believes labour shortages due to Japan’s restrictive immigration policies and market expectations of a 5% wage increase in 2025 helped pave the way for raising interest rates.

“Second, the absence of immediate, aggressive trade protectionism from President Trump following his inauguration meant yen assets were not severely impacted, providing a favourable environment for tightening,” Wu said.

Japanese economy continues to deal with uncertainty

In its January outlook for economic activity and prices, the Bank of Japan expects the Japanese economy to keep growing at a robust pace this month.

However, there are still some concerns around the country’s prices and economic activity.

Changes in foreign prices and economic activity, as well as movements in commodity prices and Japanese companies’ price and wage-setting behaviour could also heavily impact the country’s economy.

This is especially true, as Japanese companies now focus more raising prices and wages, which could in turn have far-reaching consequences for foreign exchange rates.

For the fiscal year 2024, the Bank of Japan expects the annual rate of increase in the CPI, excluding fresh food items, to be somewhere between 2.5% and 3%.

For the fiscal year 2025, this rate is expected to be about 2.5%, before stabilising at approximately 2% for the fiscal year 2026.