The Bank of Japan will announce its final interest rate decision of the year around 11:00 on Friday (December 19). The market expects it to raise the benchmark interest rate to its highest level in 30 years in order to advance the goal of policy normalization set last year.



The upcoming decision could raise interest rates to 0.75%—the highest level since 1995—and according to LSEG data, the probability of the Bank of Japan raising rates is as high as 86.4%.

The interest rate hike may suppress the dollar-yen exchange rate and curb inflation, which has exceeded the Bank of Japan's target level for 44 consecutive months. However, it could also further slow down the already weak Japanese economy, which contracted in the third quarter.

Revised GDP data shows that Japan's economy contracted more sharply in the third quarter than initially estimated, falling 0.6% quarter-on-quarter, or 2.3% annualized.

With an interest rate hike almost a certainty, experts say market focus will shift more towards the Bank of Japan's policy statement following its decision. Gregor MA Hirt, Chief Investment Officer for Global Multi-Assets at Allianz Global Investors, noted in a report on Tuesday that market reactions will depend on subtle differences in the Bank of Japan's policy communication.

Signals related to the neutral interest rate (the terminal interest rate that balances inflation and economic growth), as well as comments about the weakness of the yen, will be the focus of market attention.

Bank of Japan Governor Kazuo Ueda reportedly stated earlier this month that the final interest rate was difficult to predict, with the central bank forecasting a range of 1% to 2.5%. Speaking in the Japanese Diet, Ueda said, "Unfortunately, the neutral interest rate is a concept for which we can only give a fairly broad range of forecasts."

Ueda stated that although the Bank of Japan has made efforts to narrow the range of interest rate forecasts, it must guide monetary policy accordingly given the uncertainty surrounding the exact level of the neutral interest rate.

Carl Ang, a fixed income research analyst at MFS Investment Management, said that a new estimate of the neutral interest rate may be released after Friday's meeting.

Interest rate hike pace

Japan initiated its policy normalization process last year, abandoning the world's only negative interest rate policy framework since 2016. Since then, the Bank of Japan has consistently pursued a gradual approach to interest rate hikes. Investors will be closely watching for clues from the Bank of Japan regarding the future pace of interest rate increases.

In a report released Wednesday, ING Group noted that while the market widely expects the Bank of Japan to raise interest rates again in June 2026, the bank is more likely to postpone the action until October of that year.

In contrast, Bank of America expects the Bank of Japan to begin raising interest rates in June next year, but does not completely rule out the possibility that the Bank of Japan could act as early as April given the rapid depreciation of the yen. Bank of America analysts predict that the Bank of Japan will raise its final annualized interest rate to 1.5% by the end of 2027.

Ang of MFS Investment Management stated that despite risks to Japan's policy normalization process, such as a slowdown in the US economy and strained diplomatic relations, the Bank of Japan will not deviate from its established interest rate path unless a "major shock" occurs.

Bond and Foreign Exchange Market Outlook

Hirt of Allianz Insurance Group pointed out that although the Bank of Japan did not directly respond to concerns in the foreign exchange market, if Kazuo Ueda clearly stated that he would intervene in the weak yen, it would be seen as a signal of setting a policy "bottom line".

Since November, the USD/JPY exchange rate has mostly fluctuated between 154 and 157. With the inauguration of Sanae Takaichi, a hawkish prime minister advocating loose monetary policy, in October, the yen has depreciated by more than 2.5%. On Friday, the USD/JPY pair rose slightly, gaining approximately 0.19%.



(USD/JPY daily chart, source: FX678)

Sanae Takaichi had strongly opposed the Bank of Japan's interest rate hikes during her campaign, but her stance has since softened.

The interest rate hike will also push up yields on Japanese government bonds and borrowing costs. The Japanese government has already launched its largest stimulus package since the pandemic began to revive the economy.

The Nikkei reported earlier this month that if the benchmark yield rises from the current level of around 2% to 2.5%, Japan's borrowing costs could double. Currently, the yield on Japan's 10-year government bonds is hovering around 1.970%, close to the 18-year high (1.983%) reached in the previous trading day.



(Daily chart of 10-year Japanese government bonds, source: EasyForex)

If the yield rises to 2.5%, it means that the Japanese government's interest expenses will continue to soar, reaching 16.1 trillion yen by fiscal year 2028, a significant increase from 7.9 trillion yen in fiscal year 2024.

Given concerns about fiscal policy and the possibility of the Ministry of Finance intervening in the foreign exchange market—a possibility that Finance Minister Katayama did not rule out in May—MFS's Ang expects the dollar to remain in the 150-160 range against the yen next year.

At 9:29 Beijing time, the US dollar was trading at 155.79/80 against the Japanese yen.