TOKYO – As 2026 approaches, the Bank of Japan finds itself in the unenviable position of a central bank that cried wolf.
Last week, BOJ Governor Kazuo Ueda’s board made good on its talk of higher interest rates, raising them to a 30-year high of 0.75%. Yet currency traders aren’t buying Ueda’s pledges to continue tightening in the year ahead.
It seems a rational take, indeed. With Japan skirting recession and the global outlook as uncertain as it’s ever been, Ueda’s contention that he had the latitude to hike rates again is getting eye rolls from currency markets.
Bond punters, meanwhile, don’t seem sure what to think. They’re pushing 10-year yields over 2% betting that yen weakness will force the BOJ to tighten further.
Who’s right? The odds favor the foreign exchange gang will be vindicated as growth in Asia’s No 2 economy flatlines and a pro-yen-depreciation government limits the BOJ’s latitude to continue tapping on the monetary brakes.
Since taking the helm on October 21, Prime Minister Sanae Takaichi’s government has made clear it’s relying on a weaker yen to revive economic growth and boost wages. The plan, dubbed “Sanaenomics,” is closely aligned with that of her mentor, former Prime Minister Shinzo Abe.
Between 2012 and 2020, “Abenomics” prodded the BOJ to supersize Japan’s quantitative easing program in a bid to kick off a virtuous cycle of wage gains that, in turn, boosts consumption.
It didn’t work, though. Team Abe didn’t pair it with reforms to cut bureaucracy, loosen labor markets, increase productivity, incentivize innovation and empower women.
Now, Takaichi seeks to repeat this cycle. This is why currency traders are doubting Ueda’s insistence that the BOJ will continue hiking rates in 2026. And the entire Tokyo political empire could be about to strike back in unpredictable ways.
The headwinds bearing down on the BOJ’s rate hike cycle come from all sides. At home, a 3% inflation rate is far outpacing wage gains and gross domestic product. In the third quarter, GDP shrank 2.3% year on year. This means that Japan replaced deflation with stagflation.
From the outside, US tariffs are slamming Japanese exports and thus upping recession risks. This has the BOJ scrambling to pull off as many rate hikes as it can before it’s too late.
“The urgency stems from policymakers’ recognition that the window for hiking will close once external headwinds intensify,” argues Fitch Solutions unit BMI.
One big worry for the BOJ is that an undervalued yen might increase the odds that Japan’s imports lead to increased inflation.
As Shigeto Nagai, economist at Oxford Economics notes, “a major risk is prolonged cost-push inflation due to additional supply shocks or yen depreciation. The yen could remain under pressure if fiscal concerns and the perception of an overly-dovish BOJ prevail over the impact of the yield gap.”
The trouble for Ueda is that there’s a high risk attached to the BOJ bowing to the government. It could perpetuate a sort of vicious cycle, as opposed to a virtuous one.
“If fiscal policy starts to threaten the stability of the Japanese government bond market, then we expect that the BOJ would respond by flexibly adjusting the pace of quantitative tightening by conducting a Japanese government bond (JGB) purchase to contain market turbulence,” Nagai says.
There are risks, of course, to the market’s response to higher BOJ rates. Fitch Ratings analyst Teruki Morinaga says there are two potential pitfalls to monitor.
“First, if the yen appreciates against the US dollar due to BOJ tightening, it could offset the benefits of a steeper yield curve by reducing coupon income on a yen basis, and lowering the value of foreign bonds in insurers’ portfolios,” Morinaga says.
While Japanese life insurers have trimmed foreign bond exposure, it still accounts for over 15% of their portfolios, Morinaga says. “Second,” he adds, “if monetary tightening triggers a recession, the BOJ may be forced to reverse course and ease policy again, which would be unfavorable for insurers.”
The BOJ cutting, not hiking, rates is precisely what Takaichi wants. As she told Nikkei Asia in an interview this week, Japan’s “still high” national debt level has her reluctant to engage in any “irresponsible bond issuance or tax cuts” even as the economy skirts recession. It suggests that her government’s 18.3 trillion yen ($117.3 billion) supplementary budget could be the final fiscal push for a while.
This suggests that the BOJ will be expected to take the lead in pumping up GDP. And, it follows, backstopping a national debt load that’s currently a whopping 260% of GDP. The trouble is, a rehash of Abenomics is exactly what the country doesn’t need right now. Rather than additional stimulus jolts, Japan needs a supply-side revolution, of sorts.
As economist Richard Katz observes, while “Takaichi has been called a serious policy wonk, to me, she seems lost in a world of unreality reminiscent of Donald Trump. She spouts myths that justify serving the needs of assorted vested interests.”
For example, Katz observed as far back as October, just before Takaichi became prime minister, that she supports hybrids against electric vehicles and intends to reduce subsidies for the latter, ignoring that gasoline requires oil imports.
She plans to cut aid to solar power, exclaiming that she opposes “further covering our beautiful land with foreign-made solar panels.” Takaichi wants more nuclear energy, even though reactors need new uranium every 18 to 24 months.
“And then there is the biggest fantasy of all: that fusion power will be commercially viable by the 2030s,” says Katz, author of “The Contest for Japan’s Economic Future” and the Japan Economy Watch newsletter.
“Despite great progress, most experts don’t foresee fusion becoming a commercial reality for at least another 30 years at the earliest. She declares, ‘We will protect the automotive and related industries at all costs,’ including supporting a weak yen despite its injury to consumers.”
That injury is worth exploring as Takaichi angles to make a weak yen great again. In Japan’s case, 26 years of prioritizing a soft currency over retooling growth engines undermined competitiveness.
It meant that the 14 pre-Takaichi governments that led the nation since 1998 all had little urgency to reduce red tape, make labor markets more meritocratic, launch a startup boom and narrow the gender-pay gap. It took the onus from corporate CEOs to restructure, innovate and take big risks.
Part of the drama awaiting Ueda in 2026 is avoiding the fate of Toshihiko Fukui, the last BOJ head to bring rates near their current levels. Between 2006 and 2008, Fukui’s board scrapped quantitative easing and raised rates for the first time since the late 1990s, pushing benchmark rates to 0.5%. Then came the 2008 “Lehman Shock,” and with it a return to zero rates and quantitative easing.
Yet even some senior officials in Takaichi’s Liberal Democratic Party are realizing that a quarter century of zero rates has backfired and that the plunge in the yen over the last decade is burning the nation on multiple fronts.
The ways in which a weak yen deadened the urgency to level playing fields and boost competitiveness explain why Japan Inc today is watching with alarm as Chinese EV maker BYD and artificial intelligence upstart DeepSeek shake up their respective industries, in the way Japanese corporate titans might have in the 1980s.
The main challenge now confronting Ueda’s BOJ is that the central-bank-that-cried-wolf problem is coming back to bite the institution. Currency traders aren’t buying Ueda’s spin that more aggressive rate hikes are coming. This explains why the yen has shifted down not up despite the BOJ raising rates to their highest level since 1995.
“The BOJ delivered a rate hike like everybody expected and indicated that they will continue to raise should the economy evolve as they expect,” says strategist Marc Chandler at Bannockburn Global Forex.
That economic evolution, to say the least, is a wild card. Indeed, as 2026 approaches, traders are fretting the future of the so-called “yen-carry trade.”
Twenty-six years of holding rates at, or near, zero turned Japan into the globe’s top creditor nation, allowing investment funds to borrow cheaply in yen to bet on higher-yielding assets worldwide.
That’s why sudden movements of the yen can disrupt markets worldwide. It became one of the globe’s most crowded trades, and one uniquely prone to sharp corrections.
Between erratic US policy and the specter of a fresh borrowing binge in Japan, investors have reason to be paranoid heading into 2026. And in that context, a weak yen is good news for nearly nobody.
Follow William Pesek on X at @WilliamPesek
