Tomorrow, Japan's interest rate hike is "set in stone," and the market is focused on "how to proceed next"?

The Bank of Japan is expected to raise its benchmark interest rate to the highest level in thirty years this Friday, marking an increase in the bank's confidence in achieving stable inflation targets. Market focus has shifted from "whether to raise rates" to "how the future rate hike path will unfold."

Bank of Japan Governor Kazuo Ueda and his committee members may raise the overnight lending rate by 25 basis points to 0.75% at the end of their two-day meeting. Since Ueda issued a rare and clear signal earlier this month that a rate hike was approaching, market expectations for a rate increase have continued to heat up due to strong wage growth momentum and less-than-expected damage from U.S. tariffs. This is the first time since Ueda took office that all Bank of Japan observers surveyed by Bloomberg predict a rate hike.

As the rate hike has been fully priced in by the market—overnight index swaps indicate that traders believe the likelihood of a rate hike is about 95%—investors' focus has shifted to the future policy path. If the yen exchange rate falls towards the critical threshold of 160 yen per dollar, it may force financial authorities to reconsider intervening in the foreign exchange market, while any excessive hawkish signals could reignite a sharp rise in bond yields, which may unsettle Prime Minister Fumio Kishida's government as it prepares the budget for the next fiscal year.

This rate hike will bring Japan's interest rates to their highest level since 1995, marking a complete exit from the decades-long stagnation following the bursting of the economic bubble. As the economy enters a distinctly different phase, Ueda is effectively stepping into uncharted territory, and he may wish to maintain maximum flexibility in planning the subsequent path.

Market Consensus Expects Rate Hike, Decision May Be Unanimous

The first rate hike since January is expected to be a unanimous decision, and two committee members have already called for a rate hike in the past two meetings. If Friday's vote is unanimously approved as expected, it will be the first time Ueda's rate hike actions have received full support since he took office.

A Bloomberg survey shows that all surveyed Bank of Japan observers expect a rate hike this week. The signals Ueda issued earlier this month, combined with data showing sustained wage momentum and manageable external risks, have solidified this consensus. The policy statement is typically released around noon, followed by a press conference with Ueda at 3:30 PM.

Bloomberg economist Taro Kimura noted that as the market has already digested the impact of the rate hike, the focus will shift to Ueda's guidance during the press conference. Kimura expects Ueda to maintain cautious wording, avoiding signals about the timing of future rate hikes, while the central bank may indicate that financial conditions remain accommodative, suggesting there is still room for further rate increases.

Rates Still Below Neutral Level, Future Upside Potential Remains

Although the rate hike is seen as a "done deal," the key lies in how the Bank of Japan, led by Ueda, will articulate the longer-term rate path.

According to insiders speaking to Bloomberg, Bank of Japan officials believe that even if borrowing costs rise to 0.75%, the central bank has not yet reached the so-called "neutral interest rate" level. Some officials believe that a 1% interest rate level would still be below the neutral rate. The neutral interest rate is defined as the level that neither stimulates nor suppresses economic growth The Bank of Japan has hinted that the neutral interest rate is between 1% and 2.5%. This range is derived from the "natural rate" plus a 2% inflation target. Any explicit upward revision of this concept would indicate that there is more room for interest rate hikes than previously anticipated.

Currently, Japan's inflation rate has been at or well above the Bank of Japan's 2% target for three and a half consecutive years, while its interest rate level remains the lowest among major economies. This means that even after a rate hike on Friday, the policy environment still appears accommodative to the central bank.

Balancing Exchange Rate and Bond Market Risks, Communication Faces Subtle Challenges

For Ueda Kazuo, achieving a balance between hawkish and dovish signals is a key challenge. The scholar-turned-governor tends to adopt a hawkish stance by listing reasons when raising interest rates, while appearing more dovish when holding steady.

In the context where rate hikes have been widely priced in by the market, overly dovish wording regarding the interest rate outlook could lead to a weakening of the yen. If the yen falls towards the important psychological level of 160, it could trigger a new round of currency intervention risks. Conversely, hawkish signals from the central bank may help avoid currency depreciation but could also lead to a surge in bond yields.

Political factors also add complexity to decision-making. Kishi Sanae is known for supporting stimulus policies, and this is the first interest rate change since she took office as Prime Minister in October. Analysts are closely watching whether government representatives will express concerns and how Ueda Kazuo will communicate with this stimulus-leaning Prime Minister regarding further rate hikes