Bank of Japan set to raise rates under pressure from inflation, US

The Bank of Japan is expected to increase interest rates again on Friday to combat inflation driven by rising energy costs and to strengthen the yen, under the watchful eye of the United States. Market participants are eagerly anticipating the US Federal Reserve's decision on Wednesday, following the European Central Bank's rate hike last week.

For the BoJ, which convenes on Thursday and Friday, the anticipation is relatively straightforward: some members have indicated they may raise the key rate by 0.25 percentage points to 1.25%, the highest level in over three decades. The previous increase occurred in June.

The recent surge in oil prices, primarily due to the Middle East crisis, is expected to sustain upward pressure on inflation. Simultaneously, the weak yen is driving up the cost of imported goods. Inflation accelerated in July, nearing the BoJ's two percent target. Takehiko Nakao, Japan's former currency chief and former Asian Development Bank president, told AFP that a timely 1.25 percent rate hike is necessary to curb inflation. If delayed, it could necessitate sharper future rate hikes.

Capital Economics' Marcel Thieliant anticipates inflation, excluding fresh food and energy, to rise to around 2.5 percent by early next year. If the government does not reinstate subsidies for electricity and gas, generation costs could push headline inflation well above three percent. Thieliant believes rates could exceed two percent by mid-2027.

In an attempt to bolster the yen, which declined to its weakest level against the dollar in four decades in July, central banks are considering a joint intervention in foreign exchange markets, a move initiated by the United States and Japan. This intervention, while initially having a short-lived impact, has intensified pressure on the BoJ to expedite rate hikes, according to Shigeto Nagai, an analyst at Oxford Economics.

Financial markets seem to interpret the US Treasury Secretary's demand for faster rate hikes in exchange for intervention. The economic and political repercussions of disappointing markets and the US are becoming too significant for the BoJ and government to overlook, warns Nagai. In a conversation with BoJ Governor Kazuo Ueda, Bessent expressed strong support for Japan's decisive market and monetary steps to address the significant undervaluation of the yen.