As expected, the Bank of Japan (BOJ) raised interest rates 25bp to 1.25% at its September meeting. The decision reflects the resilience of the Japanese economy, and the ongoing inflation risk emanating from the conflict in the Middle East.

However, life is likely to become more complicated for the BOJ. Specifically, I expect economic growth to decelerate in the coming period. Also, inflation risks are likely to prove greater and more persistent than current readings suggest. The BOJ, therefore, will need to perform the same juggling act as other global central banks: how to contend with slower growth and stubbornly above-target price rises.

I believe the BOJ has more work to do in order to achieve its inflation objective (2% target). However, reflecting Japan painful legacy of deflation, I expect Japan’s monetary authority to continue to precede cautiously in order to prevent another economic slump. Indeed, the BOJ has tolerated above-target inflation for the past four years. In addition, the central bank recognises monetary policy is not a particularly effective tool in dealing with supply shocks (both energy and food).

What are the implications of the BOJ’s measured approach? In an earlier blog, I suggested the BOJ would hike interest rates three times this year. I expect the third increase in December, and another two in 2027; bringing the policy rate to 2% by the end of next year. To be sure, the BOJ’s FX intervention suggests a desire to prevent the yen from weakening beyond JPY/$ 160. While I expect additional JPY strength in the period ahead, the pace of of appreciation may be slower than expected, reflecting the BOJ’s cautious policy. In addition, rising Japanese bond yields, tighter monetary policy, and a stronger JPY suggest that equity market returns may be considerably more modest than recent performance.

Economy Resilient, But for How Long?

To be sure, the Japanese economy has remained resilient in the face of large supply side shocks. Indeed, GDP advanced 1.5% (annual rate) in H1 2026: three times the pace of the past decade. In particular, despite Trump 2.0 tariffs, exports have held up surprisingly well, as Japan has boosted sales to other trading partners (Chart above). In fact, the external sector has accounted for roughly 75% of Japan’s economic growth this year. Unfortunately, however, export momentum may be slowing already, as foreign sales advanced only 0.5% in the second quarter.

Similarly, so far, Japan has handled the oil supply disruption caused by the closure of the Strait of Hormuz surprisingly well, despite relying on the Middle East for virtually all of its oil supply (Chart above).

In part, Japan’s resilience reflects its successful efforts to stockpile large quantities of petroleum prior to the Iran war (Chart above). And, despite declining 15% since March, oil inventories still cover roughly six months of daily consumption. Indeed, stocks appear to have stabilised recently, as Japan has discovered new sources of oil (Africa, Azerbaijan). Fortunately, Japan is less reliant on the Gulf for LNG supplies.

Nevertheless, the oil shock and overall uncertainty appear to be taking a toll on domestic demand (Chart above). Indeed, local spending declined in the second quarter — led by a contraction in capital spending and residential investment. Even consumer spending has slowed, as higher oil prices squeeze household’s real incomes. Therefore, combined with decelerating external demand, overall GDP growth is likely to slow in the period ahead.

BOJ Reacts Slowly to Stubborn Inflation

Despite below-target inflation readings so far this year, prices increases are higher and more stubborn than many realise. This year’s better performance is the result of the new government’s subsidies on escalating food and energy quotes. Indeed, prior to the introduction of these measures, inflation was advancing 3% YOY. And, after declining for three months, recent monthly CPI data suggests prices are advancing again at nearly a 3% pace (Chart above).

Despite stubbornly high inflation and above-target price increases for the past four years, the Bank of Japan’s monetary stance remains more accommodative the in other G7 nations (Chart above). The central bank’s caution reflects the nation’s long deflationary experience, I believe. In addition, the BOJ understands that monetary policy’s impact on the consequences of higher energy prices is limited. As a result, the BOJ has more work to do to get inflation on a path to its target. And while short-term rates could hit 2% by the end of next year, the normalisation of BOJ policy is likely to continue to proceed slowly and cautiously.

What’s It Mean For Markets?

Yen to Strengthen Further

A weak currency has been a key tool in the BOJ’s fight against deflation since the equity bubble burst in 1990, especially since the Global Financial Crisis. As a result, JPY is now significantly undervalued (Chart above).

Reflecting the BOJ’s assessment that deflation risks have receded — and under pressure from the United States — the Japanese central bank has been intervening to support the yen (JPY/$ 160 appears to be a trigger point). However, as the intervention in 2021 illustrates (as well as similar action this Spring), such measures are ineffective unless accompanied by changes in interest rate policy (Chart above).

With the BOJ’s program to normalise monetary policy set to resume, additional intervention may be more effective. However, overall BOJ caution may mean JPY’s appreciation may be slower than some anticipate. Nevertheless, I set a target of JPY/$ 145 in the period ahead.

Bond Market Vigilantes Still Stalking

Perhaps unsurprisingly, Japanese yields have risen more than elsewhere during this year’s bond market sell-off. Indeed, not only is Japan more reliant on Gulf oil than most other advanced economies, but its fiscal position is also especially precarious (Chart above). To be sure, post-Covid budgetary consolidation has succeeded in reducing Japan’s sky-high debt ratio. However, the new government has shifted gears; implementing expansionary spending programs to cushion the impact of high food and energy prices. In addition, Japan’s demographics will require substantial belt-tightening again in order to prevent a renewed surge in the debt ratio.

Therefore, I expect Japanese yields to rise to 3.5% at least, as BOJ normalises policy in the coming period. One caveat, however. As a result of the rapid rise in Japanese yields during the past 18 months, interest rate spreads have narrowed significantly relative to the USA (Chart above). Meanwhile, reflecting Japan’s historic current account surpluses, the nation has one of the world’s largest net international investment positions (next Chart). As Japanese yields become relatively more attractive, Japanese investors may reallocate overseas funds back into local markets. Likewise, if a global fiscal crisis breaks out, Japanese investors may be inclined to bring money back home — with potentially significant implications for both the bond market and JPY.

Equity Market Reliant on EPS Growth

Given this year’s rising bond yields, the Nikkei’s rally has depended on strong EPS growth (much like the USA). With Japanese equities now expensive relative to the past and other markets, I would expect the PE ratio to decline, as bond yields rise further (Chart below). Therefore, as corporate earnings growth is likely to decelerate as the economy slows, I would expect equity market returns to be more modest than in the past two years. Indeed, the Nikkei’s rally already has stalled since April.