On Monday, September 21, the global foreign exchange market repriced the Bank of Japan's decision from the previous Friday in thin trading ahead of Japan's long weekend. The policy rate was raised by 25 basis points to 1.25%, the highest since 1995, with a vote of 7 in favor and 2 against. The rate hike itself was already fully priced in, but the guidance on the pace was cautious. The USD/JPY pair weakened after the decision and is currently trading around 157. The yield on the 10-year US Treasury bond is around 4.97%, while the yield on the 10-year Japanese government bond is around 2.99%, with the spread remaining close to 2 percentage points. Respect for the Aged Day, a national holiday, and the Autumn Equinox mean the Tokyo market is closed Monday through Wednesday, and the resulting liquidity contraction will amplify the exchange rate's elasticity to interest rate differentials and external market news.

The interest rate hike has already been priced in; the market is now debating the slope of the next phase.

This adjustment raised the target for the unsecured overnight call rate from 1% to 1.25%, just three months after the June rate hike, the shortest interval since the end of negative interest rates. The interest rate level has just entered the lower bound of the nominal neutral interest rate range estimated by the Bank of Japan (approximately 1.1% to 2.5%), and the financial environment is still considered relatively loose by officials. However, policy discussions have shifted from "whether to raise rates" to "how quickly and to what extent." The 7-2 split vote is more indicative of the internal sentiment than the magnitude itself. The dissenting votes came from council members Toshiro Asada and Ayano Sato, arguing that evidence of demand-pull inflation was still insufficient and that the timing should not be too hasty. The market interpreted the split vote as the committee not yet reaching a consensus on a steeper path. The rate hike was in line with expectations, but the limited guidance on the pace of subsequent normalization failed to meet hawkish expectations, putting pressure on the yen. The "sell the fact" trading logic applies here: what is priced in is 25 basis points, what is not priced in is the probability distribution of consecutive rate hikes or a single 50 basis point hike.

The core of the new phase that Ueda mentioned is preventing overshooting rather than rushing the schedule.

At a press conference, Governor Kazuo Ueda clarified that the policy landscape has changed. He stated that core inflation, excluding temporary fluctuations, is gradually approaching 2%, and the short-term focus has shifted from pushing inflation to near the target to stabilizing it and curbing upside risks. He also listed three types of upside disturbances: the secondary transmission of the Middle East conflict to energy prices, the expansion of global demand related to artificial intelligence, and the diffusion of exchange rates to domestic prices through import costs. Inter-firm transaction prices have begun to be transmitted to the consumer end, and the chain of wage increases for sales prices is still in operation. When asked whether it was possible to raise interest rates twice in a row, or even by 50 basis points at once, Ueda stated that it would depend on the price situation, and he did not rule out any approach. He also emphasized that it is not advisable to tighten the financial environment too quickly, and the labor negotiations next spring will be an important benchmark for testing the stability of the wage-price cycle. This does not mean that action must wait until spring, but it means that accelerating the pace requires higher data thresholds. Ueda also mentioned that the quantitative impact of the expected interest rate hikes on the economy and prices will be discussed in the quarterly outlook in October. For the market, the policy function in the new phase is closer to risk management: it is better to make minor adjustments in advance than to be forced to tighten significantly after inflation has clearly exceeded 2%.

In the short term, exchange rates will still be dominated by the US-Japan interest rate differential and holiday liquidity.

During the Tokyo bond and currency market closure, the USD/JPY exchange rate fluctuated more closely following US Treasury yields and global risk appetite. The 10-year USD/JPY interest rate differential remains the core pricing anchor for carry trades. The US 10-year Treasury yield approached 5.04% last Friday, falling back to around 4.97% on Monday; the Japanese 10-year government bond yield remained relatively stable at 2.98% to 2.99% after the rate hike. A narrowing interest rate differential would alleviate selling pressure on the yen, while a widening differential would reactivate positions using the yen as the funding currency. Analysts emphasize that the near-term exchange rate is still driven by the US Treasury-Japanese government bond yield differential, and the Monday-Wednesday holiday will thin trading volume, meaning the same magnitude of external market volatility may correspond to a larger exchange rate shift. On the day of the decision, the USD/JPY pair rose to around 158 before falling back, subsequently consolidating around 157. This reflects pricing frictions, rather than the path being fixed by the policy statement. Whether carry trades will contract depends on whether there is a seasonal return of Japanese domestic investors and how the government's verbal or actual intervention expectations regarding exchange rate fluctuations are priced into risk premiums. These are all factors related to liquidity and institutional factors, and cannot be rewritten by a single 25 basis point interest rate hike.

While prices appear to be slowing, lower wages and import costs continue to constrain the yen's trading range.

The Ministry of Internal Affairs and Communications released the August national consumer price index, showing a composite year-on-year increase of 1.9%, a core index excluding fresh food at 1.7%, and a core index excluding fresh food and energy at 1.9%. Energy subsidies and gasoline-related policies lowered the composite index by approximately 0.62 percentage points, and energy prices, which rose in July, fell by 0.7% year-on-year in August. This apparent slowdown does not necessarily mean that the underlying inflation monitored by the Bank of Japan has declined. Food prices (excluding fresh food) remained at 2.7% year-on-year, and services and wage pass-through remain key observations repeatedly mentioned by Ueda. The final weighted average wage increase in the spring labor-management negotiations of 2026 is expected to be approximately 5.01%, exceeding 5% for the third consecutive year. The gap between large enterprises and SMEs persists, with SMEs seeing a wage increase of approximately 4.69%. Ueda uses next spring's labor-management negotiations as a key indicator to judge whether the wage-price cycle will continue. His logic is that if wage increases spread to SMEs and the service sector, service inflation stickiness will increase, strengthening the reason for the policy rate to move towards the upper part of the neutral range; if wage increases are concentrated in large enterprises and real wage improvements are limited, the threshold for accelerated tightening will rise. On the import side, the impact is a combination of rising oil prices driven by the Middle East conflict and the transmission of exchange rates. Strengthening domestic inflation and wage data, increased intervention risks, or signs of capital repatriation will all raise the cost of further yen weakness. These constraints alter the asymmetry of volatility rather than providing a one-way path.

Frequently Asked Questions

Question 1: Why didn't the yen strengthen in tandem with the interest rate hike to a 31-year high? Answer: The 25 basis point increase was already priced in. The market is trading on the subsequent slope. The 7-2 vote and the statement that "tightening too quickly is not advisable" reduced the near-term probability of consecutive or larger rate hikes. Carry trades were not eliminated by a single rate hike. The interest rate differential remains close to 2 percentage points, liquidity is thinner during the holiday, and the exchange rate is more likely to fluctuate with US Treasury bonds than with the nominal level of policy rates. Question 2: What exactly has changed in the new phase mentioned by Ueda? Answer: The policy objective has shifted from pushing underlying inflation close to 2% to stabilizing inflation near the target while preventing overshooting. He does not rule out consecutive or larger rate hikes, and will use next spring's forecast and the October outlook report as verification windows. This means a more flexible reaction function, but a faster pace still requires stronger evidence from prices and wages. Question 3: What data will the market focus on after the holiday? A: One set of factors is whether energy and import prices continue to transmit corporate price increases to the consumer end; another set is whether service prices and wage diffusion support underlying inflation; and the third set is whether the US-Japan government bond yield spread and trading volume after the Tokyo market opens can absorb fluctuations in external markets. Intervention expectations and capital inflows are tail variables of exchange rates, but they do not constitute quantifiable trading guidance.