Japan’s Election Result Complicates BOJ’s Policy Path Amid Inflation, Yen Risks

 Japan’s recent upper house election outcome may place the Bank of Japan (BOJ) in a difficult policy dilemma, as renewed prospects for expansive fiscal spending threaten to keep inflation elevated while political gridlock and global trade tensions argue for caution on further rate hikes.

The ruling coalition, led by Prime Minister Shigeru Ishiba, suffered a significant setback in Sunday’s election, driven in part by voter frustration over rising living costs. Inflation has remained above the BOJ’s 2% target for over three years, intensifying internal debate at the central bank over how to respond.

The loss has left Ishiba’s coalition in the minority in both chambers of parliament, forcing it to negotiate with opposition parties, many of which are demanding aggressive fiscal measures, including tax cuts and expanded public spending.

In a press briefing on Monday, Prime Minister Ishiba reaffirmed his intention to remain in office and pledged to work with opposition leaders to introduce measures that would cushion households from the impact of persistent inflation. While proposals to reduce the consumption tax face legislative hurdles and risks to Japan’s fiscal health, analysts expect an autumn supplementary budget to be more feasible. That package could exceed last year’s ¥14 trillion ($95 billion), especially amid mounting pressure to respond to U.S. tariffs already impacting Japan’s key automobile sector.

BOJ Faces Cross-Currents: Inflation vs. Stability

For the BOJ, the shifting political landscape and uncertain external environment pose a significant challenge to policy normalization. Some board members have begun voicing concern over entrenched price pressures. Junko Koeda recently highlighted the risk of second-round effects from rising rice costs, while Hajime Takata argued for resuming rate hikes after the current pause, stating that Japan was approaching sustainable inflation.

Naoki Tamura, among the more hawkish policymakers on the board, warned late last month: “If upward inflation risks intensify, the BOJ must act decisively as a guardian of price stability.”

However, the political instability may delay decisive action. A prolonged period of legislative stalemate, combined with external headwinds such as a global trade war, could encourage the central bank to maintain a cautious stance. Analysts also warn that the uncertainty may weigh on the yen, which in turn could amplify import costs and inflation.

Yen Volatility and Market Sentiment in Focus

The yen’s trajectory is expected to play a pivotal role in shaping the BOJ’s next move. Following the election, markets have adopted a wait-and-see posture. Yet concerns persist.
“With Ishiba signalling his intent to stay on, investors are cautious, but the administration’s weakened standing still poses a risk of yen depreciation,” said Tsuyoshi Ueno, economist at NLI Research Institute.

Japan’s real interest rates remain deeply negative relative to other major economies due to the BOJ’s measured pace in unwinding its decade-long ultra-loose monetary policy. While the BOJ raised short-term interest rates to 0.5% in January, Governor Kazuo Ueda has indicated that any further hikes would depend on clarity around the economic impact of U.S. trade measures.

Most economists now expect the BOJ to hold rates steady for the remainder of 2025. Yet internal projections suggest the policy rate would need to reach at least 1% to achieve a neutral stance—neither stimulating nor cooling growth.

Some analysts argue that a renewed decline in the yen could tip the balance in favour of additional rate hikes.
“Persistent yen weakness would intensify underlying inflation and could trigger policy action,” said Mari Iwashita, executive rates strategist at Nomura Securities. She sees the potential for a rate hike in October if the yen, currently trading around 147 to the dollar, falls below the 150 mark.

Though the BOJ enjoys legal independence from political interference, its policy decisions have historically been influenced by broader political and economic priorities. Its landmark stimulus programme in 2013 was launched amid pressure from then-Prime Minister Shinzo Abe to weaken the yen and end deflation. Similarly, last year’s policy exit was partly driven by mounting political calls to arrest a sharp currency depreciation.

“As far as the BOJ is concerned, the key uncertainty is whether the election will lead to a shift in the government's economic agenda, and how financial markets will respond,” said a source familiar with the central bank’s thinking.