BoJ Interest Rate Hike Looms as Japan Grapples with Weakened Yen

The Bank of Japan (BoJ) is facing increasing pressure to raise interest rates, despite being a reflationist institution. Prime Minister Sanae Takaichi's adviser, Takuji Aida, has come out in favor of a rate hike from 1% on September 18, followed by three more hikes after that.

This shift is a departure from the government's flagship growth-strategy panel, which had previously warned against a December rate rise. The BoJ's own projections already forecast core inflation between 2.5-3% for the current fiscal year, driven by crude oil and firms passing wage increases into prices.

The main cause of this change is the historic fall of the yen in late July, which reached its weakest level in nearly 40 years at ¥164 to the dollar. The Japanese government spent an estimated $85 billion over two days buying back the currency, with the US Treasury joining in by selling euros for yen.

However, this intervention did not address the interest-rate differential that produced the weakness in the first place, and selling off reserves is a finite instrument against a potentially infinite problem. The reflationist approach is now being undermined as the weaker yen raises the price of imported food and energy, undercutting the government's planned food-tax cut.

Experts warn that raising interest rates will worsen fiscal sustainability, given Japan's 10-year bond yield has already reached 3%, a level unseen since 1996. The Japanese authorities face a dilemma between strengthening the yen and dampening inflation pressures or worsening fiscal sustainability.