The Bank of Japan raised its benchmark interest rate to 1 percent on Tuesday, its highest level in 31 years, as policymakers concluded that inflation — imported through the Iran-conflict-driven oil shock and a weakening yen — had finally become sufficiently embedded to justify a decisive move. BBC Business reported the same milestone: Japan’s rate is now at the highest point since 1995, when the country was still grappling with the aftershocks of its asset-price bubble collapse. For most of the past three decades, Japan operated as a kind of monetary museum piece — an exhibit in the proposition that a rich democracy could maintain near-zero or negative interest rates indefinitely without triggering runaway inflation. That experiment now appears to be concluding, not entirely on the Bank of Japan’s preferred terms, but concluding nonetheless.
The received wisdom
The mainstream financial press has greeted the hike with cautious approval. The line is that this represents “normalisation” — a return to the kind of monetary regime that allows a central bank to actually cut rates when the next recession arrives, which is impossible when you are already at zero. The argument runs that Japan has been trapped in a liquidity-preference equilibrium for too long: businesses, households, and government have all adapted their behaviour to assume that money will always be essentially free, and that assumption has suppressed investment risk-taking, perpetuated zombie firms kept alive by cheap credit, and contributed to the productivity stagnation that has characterised the Japanese economy since the early 1990s.
Proponents of tightening also point to the yen. The currency’s dramatic depreciation over the past three years — driven in large part by the interest rate differential between Japan and the rest of the developed world — has raised import costs, hammered consumer purchasing power, and made the country’s export-driven industrial model less reliable. A stronger yen, the argument goes, would rebalance the economy toward domestic consumption and reduce the inflationary pass-through from global commodity shocks.
These are serious arguments made by serious people. The Bank of Japan did not raise rates on a whim.
A different read
But the rate hike, framed as normalisation, carries risks that the mainstream commentary is underweighting.
Begin with the scale of Japan’s public debt. At roughly 260 percent of GDP, Japan is the most indebted major economy in the world in debt-to-GDP terms. For decades, this figure was sustainable — even dismissible — because the government was borrowing at essentially zero cost. The debt was overwhelmingly held domestically, the Bank of Japan was the largest single purchaser of government bonds through its quantitative easing programme, and the yield on Japanese Government Bonds (JGBs) remained a rounding error. At 1 percent, the arithmetic changes. Slowly at first, then consequentially.
The history of sovereign debt crises is not a history of dramatic overnight defaults. It is a history of slow, grinding deterioration in debt-service capacity as rates rise, growth disappoints, and the political will to impose fiscal adjustment proves weaker than projected. Japan has avoided this trajectory so far — partly through genuine fiscal effort, partly through the extraordinary intervention of the Bank of Japan, and partly through the simple fact that near-zero rates made the debt manageable. That last pillar is now being removed, and the other two have not visibly strengthened.
There is also the question of financial system stability. Japanese banks and insurance companies have, over decades of zero-rate policy, accumulated enormous holdings of long-duration JGBs. Rising rates mean falling bond prices, which means mark-to-market losses on balance sheets. The Bank of Japan has been extraordinarily careful in managing this transition, telegraphing moves well in advance and maintaining a yield curve control framework. But the history of central banks managing rate transitions carefully is checkered: the US Federal Reserve in 2022 and 2023 oversaw the rapid repricing of bond portfolios that contributed to the collapse of several regional banks. Japan’s banking sector is more concentrated and the holdings are larger.
The international dimension is equally important. Japan has been, for years, the world’s largest source of carry-trade capital — money borrowed cheaply in yen and invested in higher-yielding assets elsewhere. As Japanese rates rise, some of that carry trade unwinds. The sudden partial unwind in August 2024 — when the Bank of Japan signalled a much smaller rate increase than today’s — triggered a global equity sell-off. At 1 percent, the incentive to hold yen-denominated assets improves, and the flow reversal, if it accelerates, will send ripples through asset prices worldwide. This is not necessarily a catastrophe, but it is a structural shift that markets are only beginning to price.
The Guardian contextualised the hike against the backdrop of Iran-war-driven inflation and the pressures on the US Fed and the Bank of England — a reminder that this is a global moment, not a merely Japanese one. Every major central bank is now navigating the same basic dilemma: inflation that originated in supply shocks but risks becoming embedded in wage expectations, and debt loads that make sustained high rates genuinely threatening to fiscal stability. Japan is further along this path than most, but it is not alone on it.
What to watch
JGB yields and bank balance sheets: The 10-year Japanese government bond yield will be the daily monitor. If it breaks significantly above the Bank of Japan’s implicit ceiling, the markets are pricing in stress.
Yen carry trade unwinding: Watch for sudden volatility in Australian dollars, Mexican pesos, and US equities — the classic carry-trade targets. A rapid yen strengthening is the signal.
Corporate Japan’s response: Japanese firms, many of which borrowed heavily at near-zero rates to finance share buybacks and offshore acquisitions, now face higher refinancing costs. Watch for earnings warnings and, potentially, asset sales.
The political reaction: Japan’s ruling coalition is already weak. A rate-rise-induced slowdown — higher mortgage costs, reduced consumer spending — has electoral consequences. The Bank of Japan’s independence has historically been respected but is not constitutionally guaranteed.
— J