Australian Dollar soars against Japanese Yen as BoJ rate hike disappoints hawks

• AUD/JPY jumps 1.54% on Friday and trades around 112.60 at the time of writing.
• The Bank of Japan raised its policy rate to 1.25%, the highest level since 1995, but its communication disappointed the most hawkish expectations.
• The Australian Dollar also benefits from expectations of further rate hikes in Australia amid persistent inflation risks.

AUD/JPY jumps on Friday and trades around 112.60 at the time of writing, up 1.54% on the day. The Australian Dollar (AUD) benefits from a sharp decline in the Japanese Yen (JPY), despite the Bank of Japan (BoJ) raising its policy rate to the highest level since 1995.

The Bank of Japan raised its policy rate by 25 basis points to 1.25% from 1%, as widely expected. The decision was approved by a seven-to-two vote, with Toichiro Asada and Ayano Sato opposing the increase in borrowing costs.

The Japanese Yen's reaction may appear counterintuitive following the latest rate hike. However, with the decision largely priced in, investors seem to be focusing on communication that is not hawkish enough to justify expectations of more aggressive monetary tightening.

The Japanese central bank noted that it must remain vigilant about several risks, including developments in the Middle East, demand related to artificial intelligence and volatility in foreign exchange markets. It also acknowledged the risk that underlying inflation could overshoot its 2% target.

BoJ Governor Kazuo Ueda nevertheless reiterated that the institution will continue to raise interest rates if developments in the economy and prices warrant further tightening. Investors are now watching for indications regarding the timing and pace of potential additional rate hikes.

The latest inflation data, however, limit expectations of faster monetary tightening. Japan's National Consumer Price Index (CPI) remained unchanged in August, while underlying inflation stood below the BoJ's 2% annual target. These figures help temper expectations of an acceleration in the rate-hike cycle and weigh on the JPY.

In contrast, Australia's monetary policy outlook remains hawkish. The Reserve Bank of Australia (RBA) keeps its policy rate unchanged at 4.35% after three consecutive increases earlier this year, while markets expect another hike to 4.6% at the next meeting.

RBA Governor Michele Bullock warned that inflation remains "too high" and that some upside risks to prices appear to be materializing, particularly due to tensions in the Middle East. Deputy Governor Andrew Hauser also indicated that further rate hikes may be necessary to bring inflation sustainably back toward the target.

The divergence in the market reaction to the monetary policy outlooks of the two countries therefore favors AUD/JPY on Friday. While Japan's rate hike was largely priced in and was not accompanied by a sufficiently hawkish signal to support the Japanese Yen, inflation risks in Australia keep the prospect of further RBA tightening alive.