At its Monetary Policy Meeting on June 16, the Bank of Japan decided to raise rates by 25bp to 1.0% in its first hike since December 2025, taking the policy rate to its highest level in 31 years.

The decision came as no surprise, since the BOJ had communicated in advance its intention to increase rates. Regarding the outlook, the statement reaffirmed that the Bank maintained its tightening stance and would "continue to raise the policy interest rate and adjust the degree of monetary accommodation."

The BOJ made no changes to its bond-buying plans for FY2026 and decided to halt further tapering of its purchases from April 2027 onward, but this was also in line with prior expectations.

The official statement noted that "the risk of a significant slowdown in the economy [due to the Middle East situation] appears to have decreased compared with a while ago" and indicated that this was one of the reasons behind the rate hike.

There were reports immediately prior to the meeting that the US and Iran were about to agree on a memorandum aimed at ending hostilities, but Governor Ueda had strongly suggested a rate hike was coming in his speech on June 3, and the news of a potential agreement had no direct impact on the decision. Improvements in the Iran situation are likely to provide support for the rate-hiking stance of the BOJ executive, which is worried about the adverse impact of supply-chain disruptions on the economy, while slightly dampening the tightening inclinations of non-executive Board members, who are more concerned about inflation risks stemming from higher crude oil prices.

Board member Tochiro Asada, regarded as a reflationist, dissented on the rate hike. His colleagues Hajime Takata and Naoki Tamura dissented on the outlook for prices, and Mr.Tamura also voted against the plan for JGB purchases. Although the rate hike passed with a 7-1 majority vote, the decision highlighted the differences of opinion that exist among Board members and gave an impression of increased uncertainty for monetary policy.

Governor Ueda was absent from the meeting, having been hospitalized for medical treatment. This was the first time since the revised Bank of Japan Act came into effect in 1998 that a sitting BOJ governor failed to attend a scheduled Monetary Policy Meeting. Although Mr. Ueda submitted his views in writing, he did not participate in the vote, resulting in an unusual situation in which monetary policy was decided by the votes of eight Policy Board members.

The lack of the governor's direct involvement in the decision undermines confidence in the Bank's policy conduct. However, Governor Ueda is only expected to spend about two weeks in the hospital, and a short-term absence is unlikely to develop into a major crisis of confidence.

That said, the fact that Deputy Governor Shinichi Uchida stood in for the governor at the press conference—which usually provides numerous indications about future monetary policy conduct—may cause some disruption to communications between the BOJ and financial markets.

With the European Central Bank (ECB) deciding on June 11 to raise rates for the first time in roughly three years and the Bank of Japan also opting to hike, global monetary policy is increasingly shifting into rate-hiking mode.

In connection with the rate-hike decisions by the ECB and the BOJ, assessments of the impact of heightened tensions in the Middle East became a major point of discussion. The economic consequences for Japan are different from those for Europe and the US. While in both cases the surge in crude oil prices has weighed on the economy and lifted prices, Asian countries such as Japan are highly dependent on crude oil shipped through the Strait of Hormuz and thus face the risk of serious oil shortages in the event of a prolonged closure of the Strait. Major supply-chain disruptions would pose enormous downside risks to the economy, and the BOJ needs to take this into account in the conduct of monetary policy.

The first oil shock, in the 1970s, is often referenced in discussions of the Bank's response to the spike in crude oil prices. Some argue that it was the BOJ's failure to promptly raise rates during that shock that allowed a wage-price spiral to take hold.

At the BOJ-IMES Conference on May 27, Governor Ueda argued that the wage-price spiral had already emerged before the first oil shock occurred and that the problem was that the BOJ was already behind the curve at that stage.

But in a speech on June 3, just one week after this symposium, Governor Ueda warned that the inflationary impact of higher crude oil prices might not be transitory and that the upside risks to underlying inflation would also have to be considered. In doing so, he sent the message that the Bank was likely to raise rates at the June MPM instead of leaving policy on hold.

This significant shift in Governor Ueda's remarks in the space of just one week raises a number of questions and has served to undermine confidence in monetary policy.

When the BOJ decided to leave policy on hold at the April MPM, three Board members argued for a rate hike and voted against the chair's proposal. In subsequent speeches, two other Board members also made remarks indicating support for an early rate hike.

If a vote had been held at this point, it is entirely conceivable that five of the nine Policy Board members would have pushed through a rate hike with a majority vote, even if the governor, who chairs the meetings, had proposed holding rates steady.

Mr. Ueda may therefore have sought to avoid the disgrace of having his proposal rejected by replacing his original proposal to leave policy on hold with a rate hike proposal just before the meeting. I suspect this may have been behind the abrupt shift in his remarks.

If so, this would be the first case under the revised Bank of Japan Act of non-executive Policy Board members leading a decision to change policy. Leaving aside the merits of implementing a rate hike in June, the fact that policy is being decided by majority vote can be seen as a sign that the BOJ's collegial and democratic policy-setting process is functioning properly.

While it is possible that financial markets will take a negative view of this split of opinion on monetary policy, I think it may also be welcomed as a signal that policy is being decided on the basis of open discussions among Board members.

At this week's MPM, the BOJ made no changes to its JGB-buying plans for FY2026, which call for tapering monthly bond purchases by ¥200bn per quarter, but decided to halt further reductions from April 2027 onward and thus slow the rate of decline in its JGB holdings. Some have interpreted this as an attempt to bolster JGB supply/demand in response to the recent rise in the 10-year JGB yield, but I suspect that in reality it was largely decided in advance.

The Bank has concluded that the decline in its JGB holdings has led to a recovery in JGB market functioning, which eases the need to rush ahead with further reductions in its bond holdings.

The BOJ appears to have determined that the recent rise in the 10-year JGB yield is due not to a dysfunctional JGB market but rather to mounting inflation concerns stemming from surging crude oil prices and concerns over a deterioration of the nation's finances.

If the Bank were to substantially revise its tapering plans under these circumstances, it would amount to an easing of balance sheet policy and would therefore run counter to the policy rate hike. That could stoke market inflation concerns and end up pushing the 10-year JGB yield higher.

The BOJ may also hope that the lack of any substantial changes to its tapering plans will encourage the government to pursue a more disciplined approach to fiscal policy by sending the 10-year JGB yield higher.

Ultimately, I expect the BOJ will again increase its JGB purchases to a level commensurate with ongoing redemptions in order to maintain its outstanding bond holdings at a constant level.

Balance sheet policies, which the major economies introduced as extraordinary and unconventional responses to the Lehman crisis in 2008, have not been unwound despite subsequent economic improvements and now form a standard part of monetary policy.

If the Bank continues to hold a substantial amount of JGBs and maintains a high level of excess reserves, it would improve funding conditions for banks but would also undermine the incentives for them to improve their balance sheets, creating a moral hazard problem. In Japan, such policies can also impede the restoration of price stability by preventing a correction in the weak yen.

The next major challenge for the BOJ once it finishes normalizing the policy rate is likely to be the normalization of balance sheet policy.

The different monetary policy stances held by executive and non-executive Policy Board members may be partly attributable to the fact that it is the executive that has contact with the government, which prefers a cautious approach to further rate hikes. Non-executive Board members are thought to have almost no such contact with government officials.

The difference may also be rooted in whether members take a short-term or a longer-term perspective on monetary policy responses to price developments. Non-executive Board members are concerned that observed inflation will overshoot and are worried that higher crude oil prices will further exacerbate this tendency. An overshoot in inflation or the outlook for inflation (inflation expectations) lowers real interest rates and makes monetary policy more accommodative. Consequently, these members favor early rate hikes due to concerns about the Bank falling behind the curve in response to upward deviations in inflation.

The executive, meanwhile, appears to be aiming for a difficult objective—specifically, it seeks to raise the policy rate, which has been kept at an exceptionally low level for an extended period of time, and stop precisely when it reaches the longer-term neutral level. Since price increases driven by higher crude oil prices are temporary and their impact on the underlying inflation rate is uncertain, the executive prefers not to rush ahead with additional tightening. The policy stance of non-executive Board members, meanwhile, is closer to that of a normal central bank.

Over the past several years, an increase in import prices due to the weak yen has lifted inflation significantly by raising the price of food and other items. However, the year-over-year change in core-core CPI, which excludes food and energy, has recently declined to around 1%, suggesting that inflation driven by currency weakness has weakened.

Between now and year-end, higher oil prices are likely to lift the price of naphtha-derived products, prompting core-core CPI inflation to overshoot again, but this will probably be a temporary development. If core-core CPI inflation, which has recently fallen to around 1%, is regarded as the longer-term trend for inflation and the real policy rate, or natural rate of interest, is assumed to be zero, the longer-term neutral level for the policy rate would be roughly 1%.

With the BOJ raising rates from 0.75% to 1.0% on June 16, the policy rate may now be approaching its longer-term neutral, or equilibrium, level. 

But as core CPI inflation (which excludes fresh food) may briefly approach 3% again, the non-executive Board members, who place greater emphasis on observed inflation and the inflation outlook, are likely to continue their strong support for further rate hikes.

Following the rate increase at the June MPM, I expect another hike at the December policy-setting meeting. While non-executive Board members' support for rate hikes may be weakened somewhat by the memorandum agreement between the US and Iran and the decline in crude oil prices, the government may also dial back its behind-the-scenes efforts to curb rate hikes to some degree. A certain amount of time is therefore likely to pass before the next hike.

Furthermore, I expect the policy rate to be raised to 1.75% (the terminal rate) by 2028. If the longer-term neutral level for the policy rate is around 1%, the policy rate is likely to be taken significantly higher than that level.

That should eventually give the BOJ room to cut rates as inflation cools.