TOKYO, Japan: The Bank of Japan raised interest rates to a 31-year high on September 18, signalling a shift toward preventing inflation from exceeding its target, leaving the door open to further increases in borrowing costs.

The central bank raised its policy rate to 1.25 percent from one percent in a 7-2 vote, its first increase in three months. Board members Toichiro Asada and Ayano Sato, newcomers appointed by Prime Minister Sanae Takaichi, dissented.

Despite the BOJ's hawkish message, the yen weakened as investors focused on the dissent from the two policymakers, who argued that the central bank should remain patient in raising borrowing costs.

BOJ Governor Kazuo Ueda said that with underlying inflation approaching two percent, the central bank's focus had shifted from pushing prices toward its target to guarding against an overshoot.

"If risks of underlying inflation overshooting two percent materialize, that could have a negative impact on Japan's economy," Ueda told a news conference.

"It's important to stabilise underlying inflation at two percent. Our policy phase has changed," he said.

Ueda did not rule out either consecutive rate hikes or 50-basis-point increases. He said, however, that the BOJ wants to act pre-emptively to avoid being forced into large moves that could unsettle financial markets.

"Ueda's message appears to be that the BOJ is keeping its option of further rate hikes open and keeping close watch on inflation to stabilize it," said Vasu Menon, managing director of investment strategy at OCBC in Singapore.

"Overall, the BOJ's decision and Ueda's comments point to a modestly hawkish medium-term stance. However, the near-term message is not hawkish enough to trigger a significant repricing of the yen."

The increase follows rate hikes by the BOJ and its European and U.S. counterparts as central banks focus on global inflation risks stemming from the Iran war-driven rise in energy costs, expansionary fiscal policies, and surging demand for AI investment.

The move takes Japanese rates closer to levels the BOJ considers neutral for the economy and marks another step away from decades of ultra-low rates that established the yen as a cheap global funding currency.

The BOJ said economic and price developments remained broadly in line with its baseline forecast but warned that underlying inflation could deviate from its two percent target.

"Wholesale inflation remains elevated, and price pressures from business-to-business trading have started to spill over into consumer prices," the central bank said.

It also said financial conditions remained accommodative following the rate increase.

The BOJ ended a decade of stimulus in 2024 and has since raised rates several times, including in June. The 1.25 percent rate is now within the BOJ's estimated 1.1 percent to 2.5 percent range for Japan's nominal neutral rate.

Japan's rate nevertheless remains below the European Central Bank's 2.5 percent and the Federal Reserve's 3.75 percent to 4.00 percent range.

Ueda said it was difficult to determine in advance where Japan's neutral or terminal rates would ultimately settle.

"We're in a phase where we need to look at various data carefully," he said. "But that doesn't mean we can move slowly."

Analysts polled by Reuters expect the BOJ to raise rates to 1.5 percent by the end of March next year and to 1.75 percent in the second quarter of 2027. Most expect the terminal rate to be at least 1.75 percent.

Markets had almost fully priced in a September rate hike after a series of hawkish BOJ signals, including its July warning about the risk of inflation overshooting its target.