Bank of Japan lifts rates as Fed inches towards cut

The Bank of Japan raised interest rates in a mostly unexpected move on Wednesday and unveiled a detailed plan to slow its massive bond buying, taking another step towards phasing out a decade of huge stimulus.

The decision, which defied dominant market expectations for the BOJ to stand pat on rates, takes its short-term policy rate to levels unseen since 2008.

At the two-day meeting ending on Wednesday, the BOJ's board decided to raise the overnight call rate target to 0.25 per cent from 0-0.1 per cent in a 7-2 vote.

It also decided on a quantitative tightening (QT) plan that would roughly halve monthly bond buying to 3 trillion yen ($19.6 billion), from the current 6 trillion yen, as of January-March 2026.

Japan's shift to tighter monetary policy contrasts sharply with the broad swing to lower interest rates by other major economies, with the Federal Reserve increasingly likely to cut rates in September as US price pressures moderate.

"Despite sluggish consumer spending, monetary officials sent a decisive signal by raising interest rates and allowing for a more gradual balance sheet reduction," said Fred Neumann, chief Asia economist at HSBC.

"Rising inflation expectations also open the path for ongoing monetary policy normalisation by the BOJ. Barring major disruptions, the BOJ is on course to tighten further, with another interest hike by the start of next year," he said.

The yen rallied as much as 0.8 per cent to an over three-month high of 151.58 per dollar immediately after the outcome, though reversed those gains. Yields on the 10-year Japanese government bonds fell slightly on the news.

Japanese banking stocks led the benchmark Nikkei higher after the hike, with higher rates expected to improve lending margins and boost investment income for banks.

In a statement, the BOJ said its rate increase was based on its view that wage hikes were broadening and prodding firms to pass on higher labour costs through increases in services prices.

Import prices were again accelerating despite some recent moderation, the BOJ said, stressing the need to be vigilant to the risk of an overshoot in inflation.

"Given that real interest rates are at significantly low levels, the BOJ will continue to raise rates and adjust the degree of monetary accommodation" if the economy and prices move in line with its latest projections, it said.

In a quarterly outlook report released on Wednesday, the BOJ roughly maintained its projection made in April that inflation would stay around 2 per cent through fiscal 2026.

BOJ Governor Kazuo Ueda is expected to hold a news conference at 3:30 p.m. (0630 GMT) to explain the decision.

The decision comes as the Fed looks increasingly set on cutting interest rates, reversing an aggressive tightening cycle that drove up the dollar and caused a painful yen sell-off for Japan. The US central bank is expected to keep policy unchanged at its meeting later on Wednesday but open the door to interest rate cuts as soon as September.

More than three-quarters of economists polled by Reuters on July 10-18 had expected the BOJ to keep rates steady this month.

The BOJ ended negative rates and bond yield control in March in a landmark shift away from its radical stimulus programme.

Ueda has said the BOJ would hike rates further if it became convinced rising wages would prop up services prices and keep inflation durably around its 2 per cent target.

He has also said the BOJ would aim to take short-term rates to levels that neither cool nor stimulate growth - seen by analysts as somewhere between 0.5 per cent and 1.5 per cent - in coming years if inflation is seen sustainably hitting 2 per cent as it projects.

In the quarterly report, the BOJ warned that inflation may be more affected by yen moves than before, given companies were already raising prices and wages.

It also said risks to the price outlook were skewed to the upside for both fiscal 2024 and 2025, underscoring the central bank's increasing alarm over building inflationary pressure.

($1 = 152.7500 yen)