Policy normalisation in Japan: how high will the Bank of Japan go?

The Bank of Japan (BoJ) has continued to raise interest rates in an effort to "normalise" monetary policy, presenting potential opportunities for discerning investors.

On 24 January, 2025, the Bank of Japan raised its key policy interest rate by 25 basis points to 0.50%—the highest it’s been in 17 years, signaling the central bank’s mounting confidence that rising wages should keep Japanese inflation at or around its 2% target. This latest step marks the BoJ’s third rate hike in a monetary policy normalisation cycle that began nearly a year ago, leaving many policy watchers and investors now wondering: Just how high might the BoJ take rates?

BoJ policy normalisation: full speed ahead?

The January rate hike is unlikely to be the BoJ’s last move higher, in our view. Indeed, ongoing policy normalisation in Japan remains one of our team’s strongest-conviction macroeconomic themes, as the central bank attempts to bring its benchmark rate up to a neutral threshold after years of ultra-accommodative monetary policy. Our current base case calls for one more BoJ rate hike in 2025 and another two in 2026, which would imply a terminal rate of at least 1.25%. Market pricing finally reflects our 2025 rate outlook for Japan, with an additional hike now priced into the latter half of the year.

The anticipation of several further rate increases over the next two years makes the BoJ an outlier among the world’s developed-market central banks, most of which appear to be in some stage of policy easing at this juncture. (See Five macroeconomic themes for 2025: a global economy in transition to learn more.) The BoJ similarly bucked the prevailing trend in 2022 when it opted not to raise interest rates, even as other major central banks were doing so in an effort to rein in stubborn inflation.

A favorable economic backdrop for rate hikes

The main reason we believe the BoJ can and will continue to gradually raise rates in the period ahead is simply that domestic economic conditions have improved recently, enabling Japan to finally break out of its multidecade deflationary spiral:

• Japanese wage growth is approaching 32-year highs, with the country’s labor unions apparently prepared to seek wage gains of 5% in the upcoming spring wage negotiations (Japan’s so-called “shunto”).
• Notably, the “virtuous wage/price cycle” described by the BoJ appears to be in play these days, with headline and core inflation readings both expected to remain at or above the bank’s targets through 2025 and 2026.
• In fact, just this past month, the BoJ upgraded its 2025 CPI forecasts to 2.4% (headline inflation) and 2.1% (core inflation), respectively.
• Leading economic activity indicators of late, such as Japan’s Tankan survey and its Purchasing Managers' Index (PMI), suggest a healthy domestic demand impulse that should put upward pressure on prices for the foreseeable future.

Japan’s 2025 spring wage negotiations may support continued wage growth

Sources: RENGO, SBJ, Macrobond, Manulife Investment Management, as of 22/1/25. The Consumer Price Index (CPI) tracks the average change of prices over time by urban consumers for a market basket of goods and services. It is not possible to invest directly in an index.

Other factors that may shape BoJ monetary policy

Along with Japan’s favorable domestic macro backdrop, other factors might also bolster the BoJ’s more hawkish policy stance going forward.

For one thing, further rate hikes would likely support the still-weak Japanese currency (the yen), which today sits near 30-year lows and is helping to push consumer prices up via more expensive imports from abroad. Also, the BoJ conducted an empirical study showing that Japan’s extended era of rock-bottom rates didn’t produce all of the desired results, underscoring the BoJ’s present need to normalise monetary policy. While there were modest positive impacts on Japan’s economy, there were also negative impacts on the Japanese bond market’s functioning and on many financial institutions’ interest margins.

From a more tactical perspective, the BoJ’s rate actions may be influenced to some degree by US monetary policy developments and global capital markets behavior. A deep rate-cutting cycle by the US Federal Reserve (Fed) may have created a headwind for BoJ rate hikes, but the Fed’s relatively less dovish position in recent months should make it easier for the BoJ to keep lifting its policy rate. The potential for market volatility in response to global trade uncertainty could also pose a risk to BoJ rate increases, given the central bank’s cautious and risk-averse tendencies. However, we perceive Japan as being less vulnerable to US tariffs than China, Europe, and Canada.

Investment implications: the long and short of it

• Long the Japanese yen: Given our high conviction in more BoJ rate hikes to come, we see the yen gaining strength versus other global currencies over short-, medium-, and long-term time horizons. From a fundamentals standpoint, for example, we believe the yen is undervalued at today’s levels and may offer investors an appealing risk/reward profile.
• Short Japanese government bonds: While Japanese government bond yields have already experienced a sustained rise, we think they may have room to climb even higher this year and next, particularly if economists and analysts boost their BoJ policy rate estimate to match ours (i.e., at least 1.25% by the end of 2026). 
• Long unhedged Japanese equities: Our team maintains a positive long-term strategic outlook on Japanese equities amid continued BoJ progress toward normalised monetary policy, encouraging corporate reforms in Japan, and surging Japanese corporate profits. At this time, the prospect of yen appreciation leads us to generally prefer unhedged equity allocations over currency hedged ones.