Investors are raising alarms that the Bank of Japan (BOJ) risks losing its credibility in financial markets if it does not accelerate interest rate hikes to combat rising inflation, as the yen falls to a four-decade low.

Expectations are widespread that the central bank will maintain its current interest rate at its widely watched Friday meeting. Last month, the BOJ increased rates by 25 basis points to 1%, and investors are now closely monitoring for any signals of faster tightening. Derivatives market traders are pricing in only one additional 25-basis-point rate hike by January of next year.

Growing concerns over funding needs and rising inflation, fueled by government spending plans, have led to sell-offs in both Japanese government bonds and the yen this year, intensifying pressure on policymakers to respond. Despite repeated official statements hinting at potential market intervention, the yen breached the 163 level against the U.S. dollar this month for the first time since 1986, marking its lowest point. Meanwhile, 10-year Japanese government bond yields have climbed to their highest levels this century, nearing 3%.

Laura Cooper, a global investment strategist at Nuveen, an asset manager overseeing $1.4 trillion, stated that the BOJ's "actions are already lagging" and its "credibility is being undermined." She added, "The verbal interventions we are seeing are not producing sustainable effects; the central bank needs to take concrete action."

Concerns that Japan is vulnerable to high energy prices are further driving the sell-offs in both bond and currency markets. The BOJ directly intervened in the currency market in April and May of this year, but that only provided a temporary boost to the yen. Investors believe that faster rate hikes could both support the yen and ease market anxiety over long-term inflation, which is negative for bond assets.

Alex Everett, an investment manager at Abrdn, noted, "The market was already worried that the BOJ's previously hawkish rhetoric would not translate into actual rate hikes. With the yen continuing to weaken and Japanese government bond volatility increasing, the market's demand for the central bank to take substantive action has further risen."

However, the BOJ faces a difficult trade-off: it is reluctant to overreact to rising inflation by pushing up financing costs for households and businesses too quickly. The latest data shows that overall inflation, somewhat suppressed by energy subsidies, rose from 1.5% in May to 1.7% in June, still below the BOJ's 2% target. Core inflation increased from 1.4% to 1.6%.

The Japanese government on Thursday lowered its economic growth forecast for the current fiscal year from 1.3% to 0.9%, citing higher oil prices expected to dampen domestic demand. This forecast is based on an assumption of the yen trading at 161.4 against the U.S. dollar, weaker than the previous estimate of 155.2. Investors worry that the combination of a weak yen and high oil prices is putting additional upward pressure on inflation.

Fiscal policies could amplify this inflationary pressure, including plans to reduce the consumption tax on food and a long-term investment program worth 370 trillion yen (approximately $2.3 trillion). These measures have heightened market concerns about long-term financing needs. Some market participants fear that political pressure might force the BOJ to artificially keep interest rates low.

However, some analysts and traders in Tokyo offer a differing view: if the central bank yields to calls and accelerates rate hikes, it could actually damage rather than strengthen its credibility. This risk is especially pronounced if the market believes the rate increases are merely a response to the yen's decline. Traders will focus on the press conference following Friday's rate decision, watching BOJ Governor Kazuo Ueda's response to questions about the central bank's policy independence and whether he delivers a hawkish tone to alter market pricing for future meetings.

Joy Yang, head of economic and strategy research for Asia at hedge fund Point72, stated, "We believe the most important hawkish signal would be if Governor Ueda clearly states at the press conference that there is no minimum waiting period for the BOJ's next rate hike." She added that other potential hawkish signals include a dissenting vote supporting an immediate rate increase or an upgrade to growth or inflation forecasts. Traders currently see a 70% probability of the next rate hike occurring in October, as priced in by derivatives contracts.

Shuichi Takashima, a forex strategist at Citigroup in Tokyo, pointed out, "If Ueda clearly outlines a path for an October rate hike, that would send a strong hawkish signal. But given the many uncertainties in the market and the long time until October, it would be very difficult for him to give a clear roadmap."