Japan faces pressure on the yen despite the interest rate hike, and the pound sterling declines against the dollar

Japan is facing pressure to halt the decline of the yen, after the currency exceeded the level of 158 against the dollar despite the Bank of Japan raising the interest rate to the highest level in 31 years, which brought the possibility of intervention in the exchange market back to the forefront in conjunction with expectations that the central bank will accelerate the pace of monetary tightening to confront a new wave of inflation. Japanese Finance Minister Satsuki Katayama confirmed on Thursday that the principles upon which the coordinated intervention between Japan and the United States in the currency market on July 31 was based remain in place, indicating Tokyo's readiness to move again in coordination with Washington if yen fluctuations become excessive or disorderly. Katayama said that “the principles in place since the previous joint intervention remain in place,” but she declined to comment on specific exchange rate levels.

Her statements gain importance after the Japanese authorities, on Friday, conducted checks on the prices of the dollar against the yen in foreign markets, according to informed sources. This move in the markets is a possible indication of a readiness to intervene, as the authorities require financial institutions to provide live prices for the currency before making a possible decision to buy or sell. The yen responded briefly, before quickly giving up its gains and falling below the 158 level for the dollar, reflecting the continued fundamental pressure on the currency.

The Bank of Japan raised interest rates last week to 1.25 percent, the highest level in 31 years, but the decision did not give the yen the support that the authorities had hoped for. Investors focused instead on the objection of two members of the bank's board with a more accommodative stance, and considered this evidence that the pace of rate hikes may not be fast enough to narrow the large gap between Japanese and American yields. But Makoto Sakurai, a former member of the Bank of Japan's board who still maintains close ties with policymakers, believes that the September meeting represented an important shift in the way the bank deals with inflation, and that rate hikes may become more regular in the coming months. Sakurai expected the bank to raise interest approximately once every three months, to reach 2 percent by June 2027, with the possibility of exceeding this level if inflation remains high near 3 percent.

The next step is likely to be to raise interest to 1.5 percent by the end of the year, most likely in December, then to 1.75 percent during the first quarter of 2027, reaching 2 percent by June. Sakurai does not rule out raising interest rates in October if the bank makes a significant upward revision to its inflation expectations in its next quarterly report.

The expected shift in monetary policy is largely driven by rising price pressures, especially after the sharp increase in energy import costs. According to Sakurai, government data show that the cost of Japan's imports of crude oil has jumped between 70 and 80 percent in recent months compared to their levels before the US attack on Iran in February, which is expected to gradually trickle down to consumer prices. Inflation could exceed 3 percent by the end of the year and remain at those levels at the beginning of 2027, which could prompt the Bank of Japan to act faster to prevent core inflation from exceeding its 2 percent target sustainably.

At the same time, inflationary pressures do not come from imports alone. The weak yen raises the cost of imported goods, while strong demand related to artificial intelligence contributes to enhancing the profits of manufacturers, which supports economic activity and adds pressures resulting from domestic demand.

Sakurai believes that the Bank of Japan has become more aware of these risks, which explains its move from focusing on ensuring the sustainability of inflation to trying to prevent prices from rising more than the target. He also pointed out that US Treasury Secretary Scott Besent's support for raising interest rates in Japan gave the central bank more room to accelerate monetary tightening.

But the irony is that raising interest rates at a faster pace may not be enough to return the yen to a sustainable upward path. Sakurai believes that investors may continue to sell the Japanese currency and government bonds because of their expectations that Prime Minister Sanae Takaichi will continue to pursue an expansionary fiscal policy. He said the yen "will not recover unless Takaichi's fiscal policy changes," adding that even if the Bank of Japan raises interest rates aggressively, that may only slow the pace of the currency's decline. This puts the authorities in front of a double equation. On the one hand, the Bank of Japan needs to tighten monetary policy to combat inflation and reduce the interest rate gap with the United States. On the other hand, expansionary fiscal policy and increased government spending may keep pressure on bonds and the yen. This explains the return of direct intervention in the currency market to the accounts. The joint Japanese-American move in July demonstrated the willingness of Washington and Tokyo to intervene when they consider that market movements have become excessive and disorderly.

With the dollar exceeding the level of 158 yen, the markets are closely monitoring the Ministry of Finance's statements and any new price checks. But Katayama was careful not to specify a specific level that could prompt the authorities to act, thus preserving the element of uncertainty for speculators. Thus, the yen enters a phase in which three lines of defense overlap: raising interest rates, possible intervention in the exchange market, and fiscal policy. If expectations of interest rates reaching 2 percent by mid-2027 are correct, Japan will be facing the fastest shift in its monetary policy in decades, but the currency’s path will remain dependent on the extent of the ability of these steps to overcome the yield gap, government spending pressures, and the high energy bill.

The pound sterling recorded its lowest level in about 3 months against the dollar, and fell slightly against the euro on Thursday, as investors considered the pound among the most affected by the repricing of the dollar sparked by the hawkish shift in the Federal Reserve’s stance last week.

The pound sterling is heading to record its fourth consecutive daily decline against the dollar, which is hovering near its highest levels in two months.

The pound fell 0.10 percent to $1.3222, its lowest level since July 1. It has declined by about 1.25 percent since Monday, while the US dollar index has risen by about 0.90 percent.

Interest rate expectations remained in focus, after Federal Reserve Chairman Kevin Warsh indicated, last week, further monetary tightening, defending the independence of the US central bank, despite repeated calls from President Donald Trump to reduce borrowing costs.

“The market is already pricing in interest rate increases from the Bank of England, which still seems somewhat unconvinced,” said Darragh Maher, chief foreign exchange strategist at HSBC, after noting that the bank decided to bet on the rise of the US dollar against the British pound.

He added: “The weak demand for labor, ahead of new pressures on real income if energy prices remain high, represents an additional challenge.”

A survey showed on Wednesday that business activity in Britain slowed this month, while inflation pressures escalated.

Bank of America said that markets may be pricing in more monetary tightening than they should, as the bank expects to raise interest rates only twice before the Bank of England begins cutting them in 2028.

Financial markets are currently pricing in about 100 basis points of interest rate increases from the Bank of England over the next 12 months, equivalent to four increases of 25 basis points from the current level of 3.75 percent. Traders see a probability of about 75 percent for an increase in November, immediately after the fall budget, while an interest rate hike in December is seen as almost certain.

The euro rose 0.05 percent to 85.98 pence, while markets priced about 100 basis points of monetary policy tightening by the European Central Bank by the end of 2027.

Bank of America's global research department expects the European Central Bank to raise interest rates by 25 basis points in December, due to a new shock in energy prices that would keep the euro zone inflation rate above the central bank's target level for a longer period.

High gas and oil prices increase concerns about inflation in Europe, in light of continuing geopolitical tensions and limited indications of a breakthrough in the Iranian crisis, which threatens to keep energy markets suffering from a scarcity of supply during the winter season, which witnesses peak demand.

The European Central Bank was among several major central banks, including the US Federal Reserve and the Bank of Japan, that raised interest rates this month, as policymakers sought to contain inflation risks.

The financial brokerage company said it remains cautious about the strength of growth that exceeded expectations in the first half of 2026, as fluctuations in data make it difficult to assess whether this improvement will continue.

The company said in a note on Wednesday: “Growth may look good, but it will likely be less robust than it is today, and we doubt that any tangible second-order effects will have emerged, that is, the impact of inflation will be transmitted to wages and other prices.”

Although action in October remains a possibility, Bank of America noted that this would likely require much higher inflation data.

Financial markets are largely in line with Bank of America's expectations for the European Central Bank, with traders pricing in a probability of about 93 percent to raise interest rates in December, according to data from the London Stock Exchange Group.

In a separate context, the brokerage firm also revised its expectations for the Bank of England on Wednesday, adding an expectation of a rate hike in November of this year, followed by another hike in February 2027.