The Bank of Japan delivered its first rate hike of 2026 at its June meeting, raising the policy rate by 25bps to 1.0%, its highest level since 1995. This marks a further step in the cautious “adjustment of the degree of monetary accommodation”, as framed by the BoJ. The process began in 2024, as persistent deflation faded and the decade-long reliance on unconventional tools no longer seemed warranted. Monetary normalisation is founded on two pillars: raising the policy rate and reducing the pace of Japanese Government Bonds (JGB) purchases. In practice, this presents a challenging balancing act. The BoJ must tighten enough to contain inflation while simultaneously avoiding destabilisation of the bond market and public finances.
The chart shows that inflation has run above the 2% target almost continuously since 2022. However, the policy rate has only been raised by a total of 110bps since the 2024 exit from negative interest rates. Monetary policy therefore remains accommodative in real terms. The Bank of Japan considers this lag between the increase in interest rates and inflation as a necessary precaution. The central bank is concerned that premature or excessive tightening could jeopardise the still-fragile momentum in wage and price growth, thereby reigniting deflation risk. But the flip-side of this caution is the risk of falling behind the curve, necessitating a more aggressive response later. Our baseline expectation is that a terminal rate of 2% will be achieved by end-2027.
The constraint on the activity side is compounded by the rise in Japanese government bond yields, which is at least as consequential. This trend began in 2022 amid the resurgence of inflation and growing fiscal concerns. The move accelerated markedly in 2024 as the BoJ scaled back its bond purchases and decided to terminate yield curve control – two policy tools that had long kept yields artificially low. Currently, the 10-year yield stands above the neutral rate corridor, as illustrated in the accompanying chart, even though the policy rate has not yet reached the corridor’s floor.
At the start of 2024, the central bank’s balance sheet exceeded 120% of GDP, making it the dominant player in the JGB market. As a result, the sustainability of public finances had become contingent on the central bank’s absorption of bond issuance – a sign of de facto fiscal dominance. By tapering its purchases, the BoJ is restoring the price-discovery mechanism, while increasing the number of bonds to be absorbed by the market. The resulting upward pressure on yields would intensify should the BoJ reduce its purchases or raise rates too quickly, with direct implications for debt service costs and broader financing conditions.
In conclusion, the unconventional practices of the past dictate the constraints of the present. Monetary normalisation cannot come at the cost of fiscal destabilisation, particularly with government debt exceeding 200% of GDP.
