Japan raises rates to 1.25% as inflation breaks three-decade freeze

For nearly three decades, Japan lived in a world where interest rates did not move. The Bank of Japan kept them at zero, a policy born from the wreckage of the 1990s asset bubble and the stagnation that followed. That era ended today. The central bank raised its benchmark rate to 1.25 per cent, the highest level since 1995, in a widely expected decision aimed at controlling inflation that has finally broken Japan's long deflationary spell.

This is the second increase in three months. In June, rates rose to 1 per cent. The pace itself is striking—the shortest interval between hikes since 1990—and it signals how urgently the Bank of Japan now views the inflation problem. The current rate of price growth sits near 2 per cent, a figure that would barely register as noteworthy in most developed economies. But in Japan, where prices on everyday goods like lunch remained virtually unchanged for three decades, even this modest inflation has unsettled millions. Macroeconomist Fujiwara Ippei, a professor at Keio University and the University of Tokyo who spent nearly two decades at the central bank, put it plainly: people in Japan are shocked by 2 per cent inflation because they have known only zero. The price of lunch, he noted, had not changed since he was a university student thirty years ago. Now it has, and the frustration is real.

The inflation itself did not emerge from nowhere. Supply shocks have driven it—rising import costs, production expenses, and the fallout from geopolitical upheaval. The COVID-19 pandemic triggered the first wave of price increases in 2021. Then came the wars in Ukraine and the Middle East, which the Bank of Japan cited today as a key factor in its decision. Demand for artificial intelligence products has also strained supply chains. And the yen has weakened to a forty-year low against the US dollar, making imports more expensive still. The central bank has been gradually raising rates since 2024 in an effort to normalize the economy after years of aggressive stimulus designed to pull Japan out of deflation.

The decision to raise rates today carries weight beyond Japan's borders. The US Treasury Secretary Scott Bessent publicly welcomed the move, noting that a stronger yen would benefit American exporters and reduce pressure on Japan to sell US assets. The Federal Reserve itself raised rates this week to between 3.75 and four per cent, and the European Central Bank announced an increase last week. The global choreography of monetary policy is tightening. Yet Fujiwara observed that the overt pressure from Washington was "quite unusual," though he believed the Bank of Japan would have raised rates regardless. What matters, he emphasized, is that the central bank preserve its independence in future decisions.

But future increases will be complicated by Japan's structural realities. The government's debt-to-GDP ratio exceeds 200 per cent—far higher than most advanced economies. When the central bank raises rates to fight inflation, it increases the cost of servicing that debt, which could destabilize the bond market. The government is pursuing an expansionary fiscal strategy, cutting taxes on food for two years starting next April and relying on public spending to stimulate growth. The theory is sound: growth would reduce the debt ratio. But it depends entirely on market confidence. Without it, long-term interest rates could spike and the yen could weaken further.

Meanwhile, the human cost of inflation is visible in Tokyo's shopping districts. At Jizō-dōri, a strip known colloquially as "Granny's Harujuku" for its popularity with older shoppers, a 69-year-old woman named Yoshikawa said she has noticed prices rising on detergent, food, and other essentials. Her pension alone does not cover her expenses, so she works part-time. "It's all a bit of a mess," she said. "The amount I receive just isn't enough." She is far from alone. Many in Japan are calling for pension increases to keep pace with the cost of living. The government's food tax cut is meant to help, but analysts worry it could create a budget shortfall.

Japan faces another demographic reckoning that will compound these fiscal pressures. This week, the country reported that more than 100,000 people are now over 100 years old—a testament to the population's health but also a stark marker of an aging society. Fujiwara warned that Japan is not merely aging; it is entering a "super-aging" phase. Medical and nursing care costs will rise massively. Government spending will have to increase. But where will the debt be absorbed? "It's going to be a very tough situation," he said. The Bank of Japan's rate increases today are a necessary step, but they are also a small move in a much larger, more difficult reckoning that Japan cannot avoid.