Japan's rate hike dilemma and its global market impact

What impact could Japan have on international financial markets?

The Bank of Japan's October meeting minutes suggest another interest rate increase could come in December, and the rationale is clear.

Core inflation reached 2.1% year-on-year in September, the highest since early 2026 and above the BOJ's 2% target. This has been driven by a weak yen and rising energy costs stemming from Middle East tensions. When food and energy are excluded, the figure stood at 2.4%. Higher oil prices compound these inflationary pressures, particularly given Japan's heavy reliance on energy imports. Consequently, oil prices remain a key factor to monitor when evaluating the BOJ's next policy steps.

Despite conditions for a rate hike being met, the BOJ has held back. A tighter monetary policy could curb inflation and relieve pressure on the yen. However, it would also raise borrowing costs, potentially dampening business activity and investment.

Another consideration is Japan's government debt, which exceeds 200% of GDP. Rather than repaying it, the government continuously rolls over maturing bonds by issuing new ones while still paying interest on its debt.

Higher interest rates would increase the cost of servicing that debt, further straining public finances and raising questions about long-term debt sustainability.

Currency intervention offers another tool to ease pressure. By selling US dollars and purchasing yen, Japanese authorities can support the currency and reduce imported inflation. Depending on its size and how markets interpret the authorities' intentions, such intervention could cause a sharp decline in USD/JPY. The yen acquired can then be removed from circulation, reducing liquidity in the economy.

However, Japan's foreign exchange reserves, though large, are not infinite. A significant portion is held in US Treasuries.

If Japan sells those bonds to support the yen instead of raising rates, Treasury yields could rise, putting pressure on global markets, especially riskier assets. Why take risks in stocks when government bonds offer a relatively safe return of around 5%?

A Federal Reserve rate cut could ease pressure on both US and Japanese markets by making the yen carry trade less attractive. But with inflation remaining high and the labor market strong, such a move seems unlikely for now.

Conversely, if the Fed moves in the opposite direction to the BOJ and the carry trade unwinds, another issue could arise: investors who borrowed yen to buy foreign assets might be forced to sell them to repay loans. This could trigger a repeat of the 2024 market sell-off.