Japan’s central bank made headlines by pushing its short-term interest rates to levels not seen in three decades. This move triggered a sell-off in government bonds and indicated the bank’s readiness to continue tightening policies as part of its strategy to normalize economic conditions.

The Bank of Japan increased its benchmark interest rates by 25 basis points, bringing them to 0.75%—a peak not reached since 1995. This adjustment was anticipated by economists surveyed by Reuters.

Despite the rate hike, the BOJ noted that real interest rates are predicted to stay “significantly negative.” The bank emphasized that favorable financial conditions will persist, providing robust support for ongoing economic activities.

In response to the BOJ’s decision, yields on Japanese government bonds experienced an uptick. The 10-year bond yield rose by approximately 5 basis points to 2.019%, and the 20-year bond yield increased by 3 basis points to 2.975%, marking their highest levels since 1999.

The yen weakened 0.25% to 155.92 against the dollar, and the benchmark Nikkei 225 stock index gained 1.28%.

Japan embarked on policy normalization last year, abandoning the world’s only negative interest rate regime that had been in place since 2016. Since then, the BOJ has consistently maintained its stance on gradually lifting rates, stating that its goal was to see a “virtuous cycle” of rising wages and prices.

Inflation has run above above the BOJ’s 2% target for 44 straight months, with data released earlier in the day showing consumer price growth at 2.9% in November. High inflation has pressured real wages that have been declining for 10 months in a row, according to labor ministry data.

The BOJ projected that core inflation — which strips out the prices of fresh food — is likely to decelerate below 2% from April to September 2026, due to a slower rise in food prices as well as the effects of government measures aimed at addressing rising prices.

Higher rates risk exacerbating the downturn in the Japanese economy. Revised GDP numbers for the third quarter showed that economy shrank more than initially estimated, contracting 0.6% quarter on quarter, and 2.3% on an annualized basis.

The BOJ said in its statement that while weakness has been seen in the economy, corporate profits were likely to remain high, and firms are expected to continue raising wages in 2026.

“It is highly likely that the mechanism in which both wages and prices rise moderately will be maintained,” the bank said, adding that the possibility of underlying inflation reaching its 2% target was rising.

The rate hike also comes at a time when JGB yields have been hitting multi-decade highs, spiking further after the decision, raising the risk of higher borrowing costs for Japan and increasing fiscal strain.

Asia’s second-largest economy already boasts of the world’s highest debt-to-GDP ratio, standing at almost 230%, according to data from the International Monetary Fund.

Rising yields could, however, support the Japanese currency. The yen has been trading around 154-157 against the dollar since November, having weakened over 2.5% since Prime Minister Sanae Takaichi, a proponent of looser monetary policy, took office in October.

After this hike, the BOJ is likely to raise its policy rate in mid-2026, taking it to a terminal rate of 1%, Shigeto Nagai, head of Japan Economics at Oxford Economics, said in a statement to CNBC before the BOJ decision.

Terminal or neutral rate refers to one that balances inflation and economic growth — it neither overheats, nor slows down the economy.

At a press conference following the rate decision, BOJ Governor Kazuo Ueda said that “We will seek to produce new estimates on Japan’s neutral rate, if needed, though I don’t think that will help us narrow the range that much,” according to Reuters.

Ueda reportedly said earlier this month that it was difficult to estimate the terminal rate, with the central bank pegging it at 1% to 2.5%.

“Looking ahead, the BOJ is likely to continue hiking rates gradually without explicitly indicating where it sees the terminal rate, Hirofumi Suzuki, chief FX strategist at Sumitomo Mitsui Banking Corporation, said in a note after the press conference.

Suzuki added that a rapid tightening was not expected, and downward pressure on the yen will continue.

Oxford’s Nagai warned that another rate hike by the BOJ could cause friction with Takaichi, if inflation declines smoothly towards 2% in the first half of 2026.

Takaichi during her leadership contest had staunchly opposed rate hikes by the BOJ, but has since softened her stance.

Nagai said that the reason why Takaichi would accept this rate hike was because of the weak yen, and that “addressing the cost-of-living crisis has become an urgent policy issue.”

In November, Japan’s cabinet approved a stimulus package totaling 21.3 trillion yen ($135.5 billion) as Takaichi seeks to boost the country’s slowing economy and offer support to inflation-hit consumers.