On Tuesday, the Bank of Japan (BOJ) elevated its interest rates to the highest level in 31 years, marking a significant move toward the normalization of its monetary policy. This decision was made in response to ongoing inflationary pressures stemming from the energy crisis linked to the conflict in Iran.

This increase in rates, the first since December, aligns the BOJ with other central banks, such as the European Central Bank, which are also adopting tighter monetary policies to address inflation concerns.

Deputy Governor Shinichi Uchida acknowledged the recent peace agreement between the U.S. and Iran, calling it a “welcome development,” while also highlighting the continued risks of inflation.

“Compared to our previous gathering, the likelihood of a severe economic downturn has lessened. However, inflationary trends are becoming more widespread, and there is a concern that underlying inflation may exceed our target,” Uchida stated during a press conference held in place of Governor Kazuo Ueda, who was absent due to medical reasons.

In a widely anticipated decision, the BOJ raised its short-term policy rate to 1% from 0.75%, marking a return to borrowing costs not seen since 1995.

The central bank noted in its announcement that the risks of a sharp economic decline due to the Middle East conflict had lessened, thanks to advancements in securing alternative energy sources.

However, they also expressed concerns about the pricing outlook, as companies have begun to quickly pass rising oil expenses onto one another, which could lead to higher consumer prices across a variety of goods.

“Given that medium- to long-term inflation expectations continue to rise, there is a risk that underlying inflation may surpass our target,” the BOJ remarked.

The decision to increase rates was reached with a 7-1 vote. Toichiro Asada, the newest board member appointed by Prime Minister Sanae Takaichi, was the sole dissenter, believing that the risks to economic growth from the Middle East conflict outweighed those related to inflation.

“The discussion was primarily centered around whether a 50-basis point increase would be considered, but no such proposal was made. Looking ahead, this is a positive signal for risk assets, suggesting that a sudden rate hike is unlikely,” commented Hirofumi Suzuki, chief FX strategist at SMBC.

“The BOJ is expected to continue with gradual rate increases roughly every six months to a year,” he added.

Following the announcement, the Nikkei 225 index surged by up to 1%, reaching a new record above 70,000. Meanwhile, the yen experienced a brief uptick before falling to 160.29 per dollar, hovering around a level that raises concerns of potential currency intervention.

The BOJ also announced a pause in its bond tapering program starting in April of next year, while maintaining monthly purchases of around 2 trillion yen (approximately $12.5 billion) in Japanese government bonds (JGBs).

Additionally, the BOJ will cease its annual review of the bond tapering strategy but remains prepared to adjust the pace of purchases as deemed necessary in future policy discussions.

The ongoing conflict in the Middle East is complicating the BOJ’s policy framework by contributing to inflationary pressures through increased oil prices, which is particularly challenging for an economy that relies heavily on fuel imports.

Although the peace agreement between the U.S. and Iran has alleviated some market concerns regarding global inflation, wholesale inflation surged to a three-year high of 6.3% in May, indicating that companies are already passing on energy-related cost increases.

Analysts anticipate that core consumer inflation will rise above the BOJ’s 2% target later this year, following a recent dip below that threshold due to government subsidies aimed at reducing utility costs.

The depreciation of the yen, which raises import costs and contributes to broader inflation, is expected to keep pressure on the BOJ to pursue further rate hikes, according to analysts.

This rate increase from the BOJ comes during a week of significant activity for global central banks. The U.S. Federal Reserve is expected to maintain its current benchmark interest rate during its meeting on Wednesday, although officials have recently indicated growing concerns about inflation, prompting some market participants to predict that the next move may be a rate hike rather than a cut.

(Note: 1 dollar is equivalent to 160.2100 yen.)