The dollar is trading firmly against the yen during the Asian session on Thursday, with the pair hovering near 163.50. The Federal Reserve's decision to hold rates steady was met with dissent from three hawkish members, and a key official's unwavering commitment to achieving the 2% inflation target has provided support for the greenback. While the dollar currently holds an advantage in the policy tug-of-war, domestic calls in Japan for the central bank to accelerate rate hikes are growing louder, potentially becoming the next major factor influencing the yen's trajectory.

A former Bank of Japan official and current professor emeritus at the University of Tokyo indicated Wednesday that the BoJ could shift from a "tolerating inflation" stance to an "actively fighting inflation" mode by December, which would imply a faster pace of rate increases. He noted that Japan is experiencing a third wave of inflation driven by Middle East conflicts, following earlier waves triggered by the Russia-Ukraine situation and domestic wage growth and rice prices. Although the third wave may be milder than its predecessors, the real concern is that underlying inflation is clearly rising and is now quite close to the 2% target, necessitating a change in the central bank's current strategy of gradual rate hikes.

Underlying Inflation 'Clearly Rising,' Gradual Rate Hikes Pose Risks

The former official stated that based on price data estimates, if the BoJ maintains its current slow pace of rate increases, underlying inflation could overshoot to 2.2% by around July next year. This scenario would be problematic, potentially forcing the BoJ into aggressive rate hikes later, which the central bank desperately wants to avoid. He believes policymakers are likely aware they need to shift from a passive position of "tolerating inflation" to an active stance focused on "fighting inflation." The key variable is the wage outlook for next year. If union and business leaders signal that wage increases will be comparable to recent years, the BoJ could shift to "anti-inflation mode" as early as December, accelerating the rate hike cadence from roughly twice a year to quarterly.

The BoJ's 'Credibility Challenge' — A Paradigm Shift from Fighting Deflation to Inflation

The professor warned that Japan's challenge in combating inflation may be more difficult than in other countries. After decades of focusing on fighting deflation, the BoJ lacks experience in tackling inflation, and its slow pace of rate hikes to date has led to market skepticism about its anti-inflation credibility. He remarked that the market is questioning whether the BoJ truly has the will and ability to keep inflation around 2%. The central bank needs to send a clear signal that it will formulate monetary policy under different rules. While the BoJ successfully dislodged inflation from zero, the challenge of re-anchoring it at 2% is just beginning.

Impact on Yen and Markets — A Hawkish Turn Could Accelerate Yen Appreciation

If the BoJ pivots to an "actively fighting inflation" mode as predicted, accelerating rate hikes would have a significant impact on the yen. With the dollar-yen pair currently near 163.50, the interest rate differential between the US and Japan remains the core variable driving the exchange rate. A BoJ shift in December and a faster rate hike pace would gradually narrow this differential, providing medium-term support for the yen. However, this logic hinges on the Federal Reserve also slowing its own pace. If the market continues to price in a September rate hike from the Fed, the yen's upside potential would be limited. For traders, signs of a policy paradigm shift at the BoJ will be a key variable for the yen's trajectory in the coming months.

BoJ at a Policy Crossroads

The analysis highlights the core challenge facing the BoJ: after decades of deflation, the central bank is learning to combat inflation. The clear rise in underlying inflation requires a shift from "tolerance" to "active" action, but global geopolitical uncertainties and the domestic wage outlook make the timing of this shift highly uncertain. If the BoJ pivots to anti-inflation mode in December, it would mark a fundamental reshaping of its policy framework, potentially signaling a significant medium-term turning point for the yen. However, as the former official noted, the challenge of re-anchoring inflation at 2% is only just beginning.