The yen has fallen too much. Will the Bank of Japan raise interest rates next month?

The Bank of Japan is signaling to the market that it may raise interest rates as early as next month.

According to a Reuters report on November 26 citing two informed sources, the Bank of Japan has been sending more "hawkish" signals over the past week, aiming to remind the market that a rate hike in December is still a realistic option. Behind this hawkish shift was a key meeting last week between Bank of Japan Governor Kazuo Ueda and newly appointed Prime Minister Sanae Takaichi, which appears to have eliminated the new government's direct political opposition to a rate hike.

The market reaction was immediate. Driven by expectations of a rate hike, the yield on Japan's 10-year government bonds soared to 1.821%. Previously, due to hawkish remarks by a member of the board, the 5-year government bond yield had already reached a 17-year high. A survey shows that just over half of economists expect the Bank of Japan to raise interest rates at its meeting on December 18-19.

Although the final decision on whether to act in December or next January is a "fine line," and largely depends on the Federal Reserve’s rate decisions, the recent statements by Bank of Japan officials reflect a growing consensus: the weak yen has become a trend, and the risk of it driving inflation is greater than ever before.

Market data shows that in recent days the yen has continued to weaken against the dollar, already falling to the "intervention" warning level—near 155.

Hawkish Voices Strengthen, Governor’s Stance Shifts

The camp within the Bank of Japan supporting a rate hike is expanding. Board member Junko Koeda said last week that given "relatively strong" prices, the central bank must continue raising real interest rates. Another member, Kazuyuki Masu, stated in an interview published on Saturday that the timing for a rate hike is "approaching."

These comments mean the two have joined two other hawkish board members who previously proposed raising the rate from 0.5% to 0.75% in September and October, though unsuccessfully.

More noteworthy is that the previously dovish Governor Kazuo Ueda has also shown a subtle shift in stance. Last Friday in parliament, he stated that the central bank would discuss the "possibility and timing" of a rate hike in upcoming meetings, contrasting his previous remarks of "no preset timetable for policy change."

Ueda further stressed that yen weakness could impact core inflation, implying the central bank now believes exchange rate fluctuations have a more lasting effect on prices.

Political Resistance Weakens, Rate Hike Window Opens

Previously, the appointment of Sanae Takaichi—seen as dovish on fiscal and monetary policy—as Prime Minister made the Bank of Japan's decision-making more complicated. However, as the yen drops to a ten-month low against the dollar, the case for a near-term rate hike has become more compelling.

Japan’s Finance Minister Katsuki Katayama stated last week that she has "no particular objection" to the Bank of Japan's path toward raising rates. After meeting with the Prime Minister, Governor Ueda also said that the Prime Minister seems to have approved the central bank's plan to gradually raise rates to guide inflation toward the 2% target.

Naomi Muguruma, Chief Bond Strategist at Mitsubishi UFJ Morgan Stanley Securities, said: "It’s clear the Bank of Japan is deliberately sending signals now to make sure the market is not caught off guard if it decides to hike rates in December." Senior strategist Katsutoshi Inadome from Sumitomo Mitsui Trust Asset Management also believes that, since neither Takaichi nor Katayama have voiced opposition, the likelihood of a rate hike in December is higher than in January next year.

Market Bets Heat Up, Fed Becomes Key Variable

As the Bank of Japan's hawkish signals increase, investors are repricing. In addition to soaring government bond yields, the market widely expects a rate hike. A Reuters survey shows all economists interviewed expect rates to be raised to 0.75% by next March.

However, the Federal Reserve’s actions remain the biggest uncertainty. The Fed will conclude its two-day meeting on December 10. If the Fed keeps rates unchanged due to inflation concerns, the dollar may strengthen and the yen may continue to depreciate, thus putting more pressure on the Bank of Japan to hike rates next month. Conversely, if the Fed cuts rates, it may support the yen and ease pressure on the Bank of Japan.

Despite these uncertainties, the latest signals from the Bank of Japan are enough to remind investors that they can no longer take for granted that low interest rates will last long-term. As Kristina Hooper, Chief Market Strategist at Man Group in New York, put it: although some in the market believe the new government will force the central bank to keep rates low, she thinks “the [Bank of Japan] has a real desire to achieve normalization of monetary policy.”

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