Bank of Japan lifts key rate to 1%, highest since 1995, as oil shock from Iran war drives inflation

Rate decision

The Bank of Japan voted 7-1 on Tuesday to raise its short-term policy rate by 25 basis points to 1%, the highest since 1995. The hike, the first since December, pushes borrowing costs further away from the ultra-loose settings the central bank relied on for decades to combat deflation. Governor Kazuo Ueda, hospitalised with an infected liver cyst, did not cast a vote; Deputy Governor Shinichi Uchida took over the post-meeting briefing. The BOJ said the monetary environment would remain accommodative even after the increase.

Inflation and the Iran war

The central bank justified the move by pointing to the pass-through of soaring oil costs from the Middle East conflict. Wholesale inflation reached 6.3% in May, a three-year high, as companies passed on higher energy prices in business-to-business transactions. The BOJ warned that "medium- and long-term inflation expectations have also continued to increase" and that there is "a risk of underlying inflation deviating above our price target." Despite annual core consumer inflation of just 1.4% in April, partly due to government fuel subsidies, the bank sees a risk that price pressures will broaden and lift the figure above its 2% target later in the year.

Japan imported roughly 95% of its crude oil from the Middle East before the war, leaving its economy acutely vulnerable to supply disruptions. The recent US-Iran memorandum has eased some fears, but Uchida cautioned that the pace of improvement in oil distribution remains uncertain. He said the BOJ assessed that the risk of a sharp economic downturn had diminished, thanks in part to progress in sourcing raw materials from non-Middle East origins.

Compared with the previous meeting, the risk of a sharp deterioration in the economy has diminished. On the other hand, price rises are broadening, and there is a risk that underlying inflation may deviate from our target.

Political dynamics and governor's absence

Prime Minister Sanae Takaichi had publicly urged caution on rate increases, but international pressure may have shifted the calculus. US Treasury Secretary Scott Bessent visited Tokyo in May and is reported to have advised Takaichi not to block a hike. A meeting between Ueda and Takaichi later that month produced what the governor called "a meaningful exchange of opinions," though a source familiar with the talks said they failed to close the gap. The vote also took place under unusual circumstances: Ueda had been hospitalised on June 9, and Uchida himself had only returned to work late last month after treatment for leukaemia.

Market reaction and outlook

Tokyo's Nikkei 225 index crossed the 70,000 mark for the first time intra-day before closing at a record 69,404.50, up 0.12%. The relief rally was driven by the absence of a larger, 50-basis-point hike, which some investors had feared. Broader market breadth was weak, however: around 70% of Prime-section shares fell on the day.

The move... was widely expected, but it's a step-change in monetary policy for Japan, given it pushes borrowing costs to levels not seen since 1995. There was some relief that the move wasn't more hawkish, with even a 50-basis-point hike having been mooted.

Looking ahead, Uchida signalled the BOJ would continue raising rates gradually if the economic and price outlook holds. Markets are pricing in a further quarter-point hike to 1.25% in the fourth quarter, according to a Reuters poll. The central bank stressed it would "manage monetary policy appropriately to avoid falling behind the curve."