The Bank of Japan (BOJ) on Friday 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 takes the central bank closer to neutral rates, and further away from the yen's cheap-funding era. A neutral rate is one that neither stimulates nor restrains the economy, while the yen's cheap-funding era refers the long stretch in which near-zero Japanese rates let investors borrow the currency cheaply to invest in higher-yielding assets abroad.

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

"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," Bessent said.

Beyond its rate push, the US stepped in last month to prop up the yen against a 40-year low — the first joint intervention since 2011, when the two countries worked together to weaken a super-strong yen after the devastating earthquake and tsunami in eastern Japan.

Japan joins a global tightening wave

Driven by shared global inflation risks, including the Iran war-related energy crunch, expansionary budgets and surging AI capital investment, Japan's monetary tightening follows previous hikes by European and US central banks. Central banks on both sides of the Atlantic have moved in the same direction in recent weeks.

The Federal Reserve raised rates on Wednesday, its first hike in more than three years, lifting the target range from 3.5%–3.75% to 3.75%–4%. The moves abroad formed the backdrop for the BOJ's own tightening days later. The Fed's unanimous decision was largely at odds with President Donald Trump, who had publicly pushed for a rate cut. The European Central Bank also raised its interest rate to 2.5% at the beginning of September. Simultaneous tightening across the Fed, the ECB and the BOJ lifts borrowing costs across major economies at the same time, rather than in any single market.

Rate hikes normally bolster a country's currency, as higher yields attract international capital. Japan, however, faces a distinctive mix of headwinds — a stubbornly weak yen, rising prices and a shrinking population — which heavily influenced the bank's decision. Seven board members approved the policy rate hike, while two opposed it.

Yen weakens despite BOJ rate hike

The rate increase did not immediately strengthen the Japanese yen. The currency fell almost 0.8% against the dollar to 157.15 following the BOJ decision, as investors focused on the two dissenting votes and the central bank's cautious policy guidance. Split votes of that kind signal that board members are not united on the pace of tightening, which is why traders weigh them as carefully as the decision itself.

The reaction underscores the difficulty facing 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 also matters for Japanese households. Because Japan depends heavily on imported energy and other goods, a weaker currency pushes up import costs and adds inflationary pressure.

Japanese authorities spent about $96.5 billion to support the currency through joint intervention with the US from late July to late August, after the yen fell to a 40-year low.

Before the BOJ's announcement on Friday, official economic indicators had shown a slight slowdown in inflation. August core inflation fell to 1.7% from 1.8%, still close to the BOJ's 2% target. The softer reading did not stop the board from proceeding with the hike. The path of inflation from here — with the bank flagging AI demand and import costs as persistent upward forces — will be a key yardstick for how quickly further steps toward neutral follow.

BOJ says AI demand is driving prices higher

According to earlier BOJ statements, AI is expected to act as a deflationary force in the medium to long term by boosting worker and corporate efficiency. In the near term, however, the central bank warned the effect will likely be inflationary, as an influx of AI capital investment stimulates demand and pushes prices higher before productivity catches up.

"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," the bank noted.

The BOJ 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.

Households in Japan hold roughly 2,400 trillion yen (HK$120.04 trillion) in assets, including about 1,000 trillion yen in savings accounts. Household debt is comparatively modest at 400 trillion yen, with more than half of it going toward mortgages. Because Japanese households hold significantly more in deposits than they owe in loans, they generally benefit from higher interest rates, according to the BOJ.