As 2026 approaches, the Bank of Japan (BOJ) finds itself in the uncomfortable position of a central bank whose warnings no longer command the market’s trust. Last week, Governor Kazuo Ueda’s policy board followed through on months of signaling by lifting interest rates to 0.75%, the highest level in three decades. On paper, the move marked a historic break from Japan’s ultra-loose monetary era. In practice, currency traders remain deeply skeptical that this tightening cycle has much life left in it.
The market reaction has been telling. Rather than rallying, the yen continued to drift lower, signaling doubt that Ueda can deliver on pledges to keep raising rates in 2026. Bond investors, meanwhile, appear conflicted. Ten-year Japanese government bond yields have crept above 2%, reflecting bets that persistent yen weakness could eventually force the BOJ to act more aggressively. Yet the foreign exchange market, which has been burned before by BOJ caution, seems convinced that economic and political realities will soon halt the tightening experiment.
At the core of this skepticism is Japan’s fragile growth outlook. The economy is flirting with recession, global demand is uncertain, and domestic inflation—running near 3%—is outpacing both wage growth and output. Japan’s gross domestic product contracted 2.3% year on year in the third quarter, replacing the deflation of the past with something arguably worse: stagflation. Against that backdrop, Ueda’s assertion that the BOJ still has room to tighten policy is being met with raised eyebrows across trading floors.
Political headwinds only complicate the picture. Since taking office on October 21, Prime Minister Sanae Takaichi has made it clear that her government sees a weaker yen as a feature, not a bug. Her economic strategy, quickly dubbed “Sanaenomics,” echoes the playbook of her mentor, former Prime Minister Shinzo Abe. Like Abe, Takaichi is betting that currency depreciation can revive growth, lift corporate profits, and eventually translate into higher wages.
Between 2012 and 2020, “Abenomics” pushed the BOJ to massively expand quantitative easing in the hope of igniting a virtuous cycle of inflation, wage gains, and consumption. While it succeeded in weakening the yen and boosting asset prices, it failed to deliver durable wage growth or productivity gains. Crucially, it was never paired with deep structural reforms—cutting bureaucracy, liberalizing labor markets, empowering women, and fostering innovation—that economists argue were necessary to make monetary stimulus truly effective.
Takaichi now appears poised to revisit that strategy. This is precisely why currency traders are unconvinced by Ueda’s hawkish rhetoric. Markets suspect that political pressure for a soft yen will limit how far the BOJ can go, regardless of what inflation data might suggest. The risk is that Tokyo’s political establishment, having grown accustomed to easy money, could again push back against monetary tightening in unpredictable ways.
The BOJ’s challenges are not purely domestic. Externally, U.S. tariffs and slowing global trade are weighing on Japanese exports, increasing recession risks just as the central bank attempts to normalize policy. Analysts at BMI, a Fitch Solutions unit, argue that this is driving a sense of urgency inside the BOJ. Policymakers recognize that the window for raising rates may close quickly if external headwinds intensify.
Yet that urgency carries its own risks. An undervalued yen raises import costs, increasing the likelihood of prolonged cost-push inflation. Shigeto Nagai of Oxford Economics warns that additional supply shocks or further yen depreciation could entrench inflation without improving real incomes. If fiscal concerns and perceptions of an overly dovish BOJ dominate investor thinking, the currency could remain under pressure despite modest rate hikes.
For Ueda, the danger lies in accommodating the government too readily. Bowing to political demands for easy policy could lock Japan into a vicious cycle—weak currency, rising import costs, stagnant wages, and repeated interventions to stabilize markets—rather than the virtuous cycle policymakers claim to seek.
“If fiscal policy starts to threaten the stability of the Japanese government bond market, then we expect the BOJ would respond by flexibly adjusting the pace of quantitative tightening,” Nagai notes, adding that renewed bond purchases could be used to contain market turbulence. Such a move, however, would undermine the credibility of the tightening cycle almost immediately.
Financial institutions are also watching closely. Fitch Ratings analyst Teruki Morinaga highlights two potential pitfalls. First, if BOJ tightening leads to yen appreciation, it could reduce the yen-denominated value of foreign bond holdings and offset the benefits of a steeper yield curve for insurers. Japanese life insurers, despite trimming exposure, still hold more than 15% of their portfolios in foreign bonds. Second, if tightening tips the economy into recession, the BOJ could be forced into another policy reversal—an outcome that would be particularly damaging for long-term investors.
Ironically, a policy reversal is exactly what Prime Minister Takaichi appears to prefer. In a recent interview, she emphasized Japan’s “still high” public debt—around 260% of GDP—and signaled reluctance to pursue further aggressive fiscal stimulus. Her government’s 18.3 trillion yen ($117.3 billion) supplementary budget may be the last major fiscal push for some time. That stance implicitly places the burden of supporting growth back on the BOJ.
This dynamic underscores the central contradiction of Sanaenomics. Japan needs growth, but it also needs to stabilize a colossal debt load. Relying on monetary policy to do both risks repeating the mistakes of the past. Many economists argue that what Japan truly needs is a supply-side revolution: reforms that boost productivity, encourage entrepreneurship, and make labor markets more flexible and inclusive.
Critics of Takaichi’s agenda are increasingly vocal. Economist Richard Katz argues that her policies reflect a nostalgia-driven worldview that serves entrenched interests rather than addressing structural weaknesses. He points to her skepticism toward electric vehicles, her desire to cut solar subsidies, and her emphasis on nuclear and even fusion power as examples of misplaced priorities that ignore economic realities and energy dependencies.
The consumer impact of a weak yen is also becoming harder to ignore. While exporters benefit, households face higher prices for food, fuel, and everyday goods. After more than two decades of prioritizing currency weakness over competitiveness, Japan’s corporate sector now finds itself under threat from disruptive foreign players. Chinese electric vehicle giant BYD and artificial intelligence newcomer DeepSeek are shaking up industries once dominated by Japanese champions, exposing the cost of delayed reform.
For Ueda, the stakes are personal as well as institutional. He is keenly aware of the fate of former BOJ Governor Toshihiko Fukui, who raised rates to 0.5% in the mid-2000s only to see the effort undone by the 2008 global financial crisis. A similar reversal would further damage the BOJ’s credibility and reinforce the perception that Japan cannot escape its zero-rate trap.
That credibility problem is already evident. The yen’s weakness following last week’s rate hike suggests that markets see the BOJ’s tightening talk as conditional at best. As strategist Marc Chandler of Bannockburn Global Forex notes, the central bank delivered exactly what was expected—and little more. The promise of future hikes depends on an economic evolution that remains highly uncertain.
Adding to the unease is the fate of the yen carry trade. Decades of near-zero rates turned Japan into the world’s largest source of cheap funding, allowing investors to borrow yen and invest in higher-yielding assets abroad. Sudden yen movements can now ripple through global markets, making the currency one of the world’s most crowded and volatile trades.
With erratic U.S. policy, fragile global growth, and Japan’s own unresolved contradictions, investors are entering 2026 on edge. In that environment, a persistently weak yen offers little comfort. For consumers, it erodes purchasing power. For policymakers, it exposes the limits of monetary maneuvering. And for markets, it raises a troubling question: when the BOJ finally cries wolf again, will anyone believe it?
