BOJ raises rates to a 31-year high as AI demand adds to inflation risks

On Friday, the Bank of Japan(BOJ) raised its benchmark interest rate from 1% to 1.25%, the highest level since 1995, as it moves to combat economic strain and normalize borrowing costs.

The increase marks the first rate hike since June and moves the BOJ closer to neutral rates and further away from the yen’s cheap-funding era.

The US had previously pushed Japan to raise interest rates sooner. Until now, the BOJ had generally waited six months between hikes in recent years, but the latest increase comes after only three months. US Treasury Secretary Scott Bessent had asked BOJ Governor Kazuo Ueda to take appropriate monetary policy action to stem the yen’s weakening.

He contended, “I have information that the market doesn’t have, and it’s my belief that the Japanese government and the BOJ will do the things that will lead to a stronger yen.”  

Nonetheless, aside from its rate push, the US stepped in last month to prop up the yen against a 40-year low. This was actually the first time they’ve done a joint intervention since 2011, back when they had to work together to weaken a super-strong yen after the terrible earthquake and tsunami in eastern Japan.  

Japan joins other central banks worldwide in increasing rates

Driven by common global inflation risks, such as the Iran war-related energy crunch, expansionary budgets, and surging AI capital investments, Japan’s monetary tightening follows previous hikes by European and US central banks.

Normally, rate hikes bolster a country’s currency, as higher yields attract international capital. At the moment, Japan is facing a unique mix of headwinds, including a stubbornly weak yen, rising prices, and a shrinking population, which heavily influenced the bank’s decision. 7 board members approved the policy rate hike, while 2 opposed it.

Yen weakens despite BOJ rate hike

The rate increase did not immediately strengthen the Japanese yen. The currency fell almost 0.8 percent against the dollar to 157.15 yen following the BOJ decision, as investors were more concerned about the two dissenting votes and the Bank of Japan’s cautious policy guidance.

The reaction indicates the difficulty for the BOJ. Higher Japanese interest rates can make yen-denominated assets more attractive, but the currency remains under pressure when interest rates in other major economies are much higher.

The weak yen is also important for Japanese households because Japan relies heavily on imported energy and other goods. A weaker currency means that imports will go up, putting inflationary pressure on it.

Japan and the US have recently made a rare joint intervention to boost the yen after it fell to a 40-year low. Japanese authorities spent about $96.5 billion to support the currency from late July to late August.

However, before the BOJ’s announcement on Friday, official economic indicators showed a slight slowdown in inflation last month. August core inflation fell slightly to 1.7% from 1.8%, still close to the BOJ’s 2% target. 

BOJ says AI demand is driving prices higher

According to earlier BOJ statements, AI will serve as a deflationary force in the medium- to long-term by boosting worker and corporate efficiency. However, the central bank warned that the near-term reality will likely be inflationary, as an influx of AI capital investments stimulates demand and pushes prices higher before productivity catches up. 

It noted, “The increased demand arising from the AI buildout will exert upward pressure on both economic activity and prices. Furthermore, the global market prices of items such as memory chips and copper wiring are rising in reflection of global supply and demand conditions, giving additional upward push to prices in Japan.”

It further expects AI-related demand to continue affecting the broader economy, while the lingering impact of yen weakness on import costs could keep domestic inflation elevated. “Our estimates suggest that AI-related demand can exert a sticky and lasting upward influence on consumer inflation excluding fresh food and fuel,” it said.

Overall, households in Japan have roughly 2,400 trillion yen (HK$120.04 trillion) in assets, including roughly 1,000 trillion yen in savings accounts.

Household debt is also pretty modest at 400 trillion yen, with more than half of it going toward mortgages. Since Japanese households hold significantly more in deposits than they owe in loans, they generally benefit from higher interest rates, according to the BOJ.

If you're reading this, you’re already ahead. Stay there with our newsletter.