The Bank of Japan on Wednesday raised its policy interest rate to around 0.25 percent and decided to slow the pace of its government bond buying to 3 trillion yen ($20 billion), in a further shift toward policy normalization as the nation battles a weakening yen.
In its first increase since the symbolic end of its negative rate policy in March, the BOJ judged it appropriate to lift short-term interest rates to their highest level since 2008, from a range of zero and 0.1 percent.
BOJ chief Kazuo Ueda said economic and price developments are "on track" with their forecasts, but warned of upside risks to prices, especially due to the precipitous drop in the yen. Depending on incoming economic data, an additional interest rate hike may be possible, he added.
The combination of a rate increase and a reduction in government bond purchases had not been ruled out but was seen by many analysts as unlikely, given the fragility of the Japanese economy, especially private consumption.
The yen jumped to the 150 level versus the U.S. dollar from 153 in Tokyo while the yields of the benchmark 10-year Japanese government bonds rose after the BOJ announcement. The U.S. Federal Reserve, which is expected to start cutting rates in September, wraps up its policy meeting Wednesday.
"The (headline) inflation rate has been consistently above 2 percent for an extended period. In view of further upside risks to inflation, we thought now was the right time," Ueda told a press conference.
"I don't think the rate increase will have a serious negative impact on the economy because it's still at low levels," he said.
As the BOJ embarks on quantitative tightening, a process to reduce asset holdings on its bloated balance sheet, its bond buying will be halved from the current 6 trillion yen a month by March 2026.
The taper plan is estimated to lead to a 7 to 8 percent decrease in the central bank's government bond holdings, which have totaled a whopping 600 trillion yen.
"It will still be far from a desirable size. We will determine exactly what would be the preferable level by looking at other central banks (reducing their balance sheets after monetary easing)," Ueda said.
The tapering pace may change, the BOJ said, adding that it will carry out buying "flexibly" to prevent a surge in bond yields. It will also review the purchase plan in June 2025.
The latest outcome reflects the BOJ's growing confidence about the possibility of achieving its 2 percent inflation goal, accompanied by wage growth.
Senior ruling party lawmakers had piled pressure on the central bank to consider raising interest rates in the run-up to the policy meeting as a way to salvage the yen's drop, a reflection of the wide interest rate gap between Japan and the United States.
Prime Minister Fumio Kishida said the government and the BOJ are "on the same page" over the need for the economy to shift to a new growth model. "Clear signs have emerged that that transition is taking place" as evidenced by the BOJ move.
Higher interest rates mean businesses and households need to pay more to take out loans. Meanwhile, consumers benefit from higher deposit rates on their savings in cash-loving Japan.
Financial institutions, which have long suffered from low interest rates, will likely see their profitability improve.
During the press conference, Ueda said private consumption remains solid, wage growth has spread from large firms to smaller ones, and inflation expectations are heightening.
But he noted that there is "some distance" before the BOJ can say the 2 percent inflation target can be attained in a stable and sustainable manner.
In a newly released report, the central bank said core consumer prices, excluding volatile fresh food, are now expected to rise 2.1 percent in fiscal 2025, revised up from its previous outlook of 1.9 percent.
The BOJ trimmed its inflation outlook for fiscal 2024 to 2.5 percent from 2.8 percent in the April report, though the figure is still above its 2 percent target. The key gauge of inflation is projected to stay at around 2 percent in fiscal 2025 and 2026.
"BOJ may want to go as far as they can in the latest rate hike cycle...so they will continue to seek the next timing by looking at economic conditions," said Toru Suehiro, chief economist at Daiwa Securities Co.
But he added, "I don't think conditions will fall into place for the BOJ to continue raising rates with confidence."
The inflation rate is still markedly lower than in the United States and Europe, but it is historically high for a nation long mired with deflation, or when prices continuously fall.
With wage growth offset by inflation, weak private consumption casts doubt on the economy, which is widely expected to rebound from a sharp contraction in the January-March quarter.
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