By Leika Kihara
TOKYO, Sept 18 (Reuters) - The Bank of Japan is set to raise interest rates to a 31-year high on Friday and pledge to deliver more to counter inflation risks, which may heighten if the start of a U.S. rate-hike cycle weakens the yen against the dollar.
The widely expected move would be the first hike in three months and take interest rates closer to levels the BOJ deems neutral to the economy, marking another step away from decades of ultra-low rates that cemented the yen's status as
a cheap global funding currency.
But the Federal Reserve's rate hike on Wednesday and prospects of another move later this year have piled pressure on the BOJ to keep pace, as a widening of an already big U.S.-Japan rate gap could weaken the yen and lift inflation through higher import costs, analysts say.
Such pressure could affect the tone of BOJ Governor Kazuo Ueda's post-meeting briefing, which will be closely watched by markets for clues on the timing and pace of further increases.
"The BOJ will be under huge pressure after the Fed hiked rates and kept market expectations alive for more," said Takeshi Ishida, strategist at Kansai Mirai Bank. "The hurdle for Ueda's news conference has heightened."
At the two-day meeting ending on Friday, the BOJ is set to raise its policy rate to 1.25% from 1%. Board member Toichiro Asada, who dissented to the rate hike in June, may do so again, analysts say.
A hike to 1.25% would bring the BOJ's policy rate to levels unseen since 1995. It would also bring the rate within its estimated 1.1% to 2.5% range of Japan's nominal neutral rate, or the level that neither cools nor overheats growth, thus raising questions about how far it could eventually hike rates.
The BOJ exited a decade-long stimulus in 2024 and raised rates several times, including in June, at a pace of roughly twice a year on the view Japan was making progress in durably achieving its 2% inflation target.
Critics say the slow pace of BOJ hikes has been among factors keeping the yen weak which, along with surging energy costs from the Iran war, have led to a spike in wholesale inflation that is seen spilling over to consumer prices.
Even with Friday's expected hike, the BOJ still lags global peers with its policy rate lower than that of the European Central Bank, which raised its key rate last week to 2.5%, and the Fed's 3.75%-4.00% range.
Markets have nearly fully priced in September rate hike after a slew of hawkish BOJ signals, including its warning in July of the risk of an inflation overshoot from soaring fuel costs, rising import costs from a weak yen and strong AI demand.
U.S. Treasury Secretary Scott Bessent also piled in, saying he voiced his strong support for "decisive" monetary steps to combat yen weakness in a meeting with Ueda this month, held on the sidelines of a G20 finance leaders' gathering.
But many BOJ officials, including Ueda, have remained vague on the potential speed and degree of future rate hikes, arguing that much would depend on the inflation outlook and how the bank's past rate hikes could affect financial conditions.
Analysts polled by Reuters expect the BOJ to hike rates to 1.25% this month, 1.5% by end-March next year and then to 1.75% in the second quarter of 2027. Most saw the terminal rate as being at least 1.75%.
(Reporting by Leika Kihara; Editing by Sam Holmes)
