Landmark increase to 1% signals a decisive break with Japan’s era of ultra-cheap money as policymakers confront inflation, expensive energy and a weakened yen

The Bank of Japan has raised its benchmark interest rate to its highest level in more than three decades, marking another significant step away from the ultra-loose monetary policies that defined the country’s long struggle against deflation.

At the conclusion of its two-day policy meeting on Tuesday, the central bank increased its short-term policy rate by a quarter of a percentage point, from 0.75% to 1%. The rate has not stood at this level since 1995.

The decision represents a historic milestone for an economy in which borrowing costs remained close to—or below—zero for much of the past generation. Japan’s central bank spent years attempting to encourage investment, consumer spending and price growth through negative interest rates and large-scale purchases of government bonds.

That era is now steadily being dismantled.

Inflation replaces deflation as the central concern

The latest increase was approved by seven members of the Bank of Japan’s policy board, with one voting against it. Policymakers said inflationary risks had intensified, particularly because of higher energy costs and the continuing weakness of the yen.

Japan imports most of the oil and natural gas it consumes, leaving households and businesses especially vulnerable to disruptions in global energy markets. Recent instability in the Middle East has pushed up fuel prices and increased fears that more expensive energy could spread through the wider economy.

Higher import costs are already affecting manufacturers, transport companies and retailers. Businesses may eventually pass these expenses on to consumers, making it more difficult for the central bank to keep inflation close to its 2% target.

Wholesale inflation reportedly accelerated sharply in May, strengthening the argument for tighter monetary policy. Although recent diplomatic developments have eased some concerns over energy supplies, officials remain cautious about the outlook.

The Bank of Japan said the domestic economy continued to recover moderately, supported by government measures and private-sector activity. It nevertheless warned that expensive oil could weaken corporate profits and reduce household purchasing power.

For decades, Japan was viewed as the world’s leading example of entrenched deflation. Weak demand, slow wage growth and an ageing population repeatedly prevented prices from rising sustainably.

The central bank responded with increasingly unconventional policies. It cut interest rates to zero, introduced negative rates and bought enormous quantities of government bonds in an effort to lower financing costs and stimulate economic activity.

Japan finally ended its negative-interest-rate policy in 2024. Since then, the Bank of Japan has gradually increased borrowing costs as inflation and wages became more persistent.

The latest move to 1% demonstrates how dramatically the economic debate has changed. Instead of trying to create inflation, policymakers are now attempting to prevent it from becoming excessive.

Even so, Japanese rates remain low compared with those of many other major economies. The central bank is therefore expected to proceed cautiously rather than begin a rapid sequence of increases.

The yen remains another major concern for policymakers.

A weak currency makes Japanese exports more competitive overseas, benefiting manufacturers such as automobile and electronics companies. However, it also raises the domestic cost of imported food, fuel and raw materials.

With the yen trading near historically weak levels against the US dollar, the resulting increase in import prices has added to pressure on household budgets. Raising interest rates can support the currency by making yen-denominated assets more attractive to investors, although the effect depends heavily on interest-rate policies in the United States and elsewhere.

The currency’s limited reaction following the announcement suggested that investors had largely anticipated the increase.

Japanese equities also remained resilient. The Nikkei 225 briefly climbed above 70,000 points before giving up some of its gains, indicating that markets did not view the rate increase as an immediate threat to corporate growth.

Higher costs for households, companies and government

The return of higher interest rates will gradually affect mortgages, business loans and other forms of borrowing.

Japanese households with variable-rate home loans may face increasing monthly payments. Companies that became accustomed to exceptionally cheap credit could also encounter higher financing costs when refinancing existing debts or funding new investments.

Banks, however, may benefit from wider lending margins after years in which near-zero rates constrained profitability. Savers could also receive better returns on deposits, although these gains may be limited if inflation remains elevated.

The consequences for the Japanese government could be particularly important. Japan carries one of the largest public-debt burdens among advanced economies, and rising bond yields could eventually increase the cost of servicing that debt.

Alongside the rate decision, the Bank of Japan adjusted its plans for reducing government-bond purchases. Policymakers indicated that the tapering process would proceed carefully, reflecting concerns that an abrupt withdrawal from the bond market could produce excessive volatility.

Governor Kazuo Ueda did not participate in the meeting because he was receiving hospital treatment. Deputy Governor Shinichi Uchida assumed the central role in communicating the decision and explaining the central bank’s assessment.

The unusual absence did not prevent the board from approving a move that financial markets had widely expected.

Officials stressed that future decisions would depend on incoming economic data, particularly wage growth, consumer inflation, currency movements and developments in global energy markets.

The central bank is likely to avoid committing itself to a fixed timetable. Further increases may follow if inflationary pressure persists, but officials will also be alert to the danger that higher borrowing costs and energy prices could weaken economic growth.

Japan’s rise to a 1% policy rate may appear modest beside borrowing costs in the United States or Europe. In the context of Japanese economic history, however, it represents a profound transition.

A country once associated with falling prices, negligible wage growth and permanently cheap money is moving toward a more conventional monetary system.

Whether that transition can be completed smoothly remains uncertain. The Bank of Japan must contain inflation without suppressing household spending, damaging heavily indebted businesses or destabilising the government-bond market.

Tuesday’s decision nevertheless sends a clear message: Japan’s age of near-zero interest rates is no longer the unquestioned norm.