The dawn of 2026 finds Japan confronting a scenario that would have sounded implausible a few years ago: officials openly warning of currency intervention as the yen drifted toward 160 per dollar, even after the Bank of Japan lifted its policy rate to a 30-year high of 0.75 per cent in December.
In the textbook story, higher interest rates and rising bond yields should support the currency. Yet Japan’s experience suggests that when an economy is moving out of a long-established regime, markets do not behave like tidy variables in a classroom model. They behave like forward-looking prices, absorbing not only the latest rate decision but also investor judgement about fiscal arithmetic, institutional credibility and what the new normal might actually look like.
Placing Japan alongside Pakistan and Turkiye may appear like forcing a comparison. Their structures and institutions are not comparable in any strict sense. But the comparison is suddenly useful in one respect: all three are living through moments when public debate relies on simple slogans – ‘raise rates to cut inflation’, ‘cut rates to boost growth’, ‘high rates cause inflation’ – and the world responds in more complicated ways.
A brief primer for general readers: the interest rate we observe in an economy has two components. One is the real part – what a lender earns after adjusting for inflation. The other reflects expected inflation – what borrowers and lenders anticipate prices will do over the life of the loan. Put simply, the nominal interest rate is the sum of a real return plus expected inflation. This is just a convenient way to separate returns in purchasing-power terms from those in money terms.
Confusion begins when this accounting relationship is read as a one-way policy rule. If nominal rates move, which one of the two components is changing, and in which direction does causality run? Neo-Fisherians frame the issue as a provocative thought experiment: if a central bank holds nominal rates very low for a long time, might it also end up anchoring inflation expectations low, because the public comes to treat low inflation as the regime?
And conversely, if the central bank credibly raises nominal rates and sustains them as a lasting new normal, could inflation expectations gradually rise to align with that higher nominal-rate path? In its strongest form, the claim is deliberately counterintuitive: a durable increase in nominal rates could be associated with higher inflation in the long run -not because higher rates ‘cause’ inflation mechanically, but because expectations and the perceived policy regime adjust over time.
Mainstream central banking distinguishes between the short and the long run. Rate hikes usually curb inflation by tightening credit, cooling demand and weakening pricing power. Neo-Fisher effects rely on permanent, credible regime change; temporary moves behave conventionally. In reality, exchange rates, fiscal risks, politics and credibility shocks often dominate, making any one theory risky to treat as a slogan.
Turkiye offers the starkest test of rate slogans. After the early-2000s disinflation and the adoption of inflation targeting, policy was conventional, then blurred by complex tools. The real break came when politics imposed low rates despite rising inflation. The public learned not theory but practice: tightening had limits, especially when inflation surged.
Once that belief takes hold, the emerging-market sequence becomes familiar, and Turkiye’s version was unusually stark. The exchange rate typically moves first. Depreciation lifts the domestic price of imports and tradables; firms hedge defensively; inflation rises through pass-through. Then comes the part that confuses casual observers: market interest rates can climb even if the policy rate is held down or cut. Investors demand compensation for higher expected inflation and greater risk, so longer-term borrowing costs embed those premia. The result is a damaging mix: high inflation, a weaker currency and higher effective financing costs for households, firms and the sovereign.
Against this backdrop, Turkiye’s recent moves are best read as a credibility problem rather than a clean experiment. A rate cut can be sensible if inflation is genuinely falling and expectations are anchoring. But where inflation has been entrenched, the stance is not just about the policy rate level but also about whether people believe the reaction function has truly changed, including the willingness to stay tight when it is politically costly. If that belief is absent, the exchange rate becomes the barometer again and risk premia return through the very market rates policymakers hope to reduce.
Pakistan’s story is different in origin but similar in fragility. The country is not trying to escape a deflation trap; it is trying to preserve disinflation without reactivating the exchange-rate channel. A rate cut after disinflation can be fully consistent with a central bank’s mandate. But Pakistan’s constraint is structural and recurrent. The exchange rate is not a side variable; it is often the transmission line through which stress returns. When foreign exchange inflows slow, when imports are compressed, or when uncertainty rises, the currency adjusts. Pass-through follows. Inflation returns through tradables prices rather than a domestic demand boom.
That is why Pakistan’s monetary policy rarely gets judged solely on domestic inflation forecasts. It is judged through external buffers, market functioning and the credibility of the broader stabilisation path. Pakistan is not trying to lift inflation expectations by committing to a higher nominal-rate regime; it is trying to prevent expectations from re-accelerating when the currency becomes fragile. The practical intuition is blunt: easing is sustainable only if external vulnerability is falling, not merely if the latest inflation print looks comforting.
Japan completes the triangle by showing that non-textbook outcomes are not confined to emerging markets. The move to 0.75 per cent marked a historic break with decades of near-zero rates. Yet the yen weakened through early 2026, prompting officials to adopt sharper intervention language as it approached politically sensitive levels. The temptation is to interpret this as a failure of tightening. But Japan’s situation is more subtle. Markets are not only trading rate differentials; they are trading the regime transition itself.
In a high-debt sovereign, rising yields do not simply mean higher returns. They also raise questions about debt-service costs, fiscal responses and the political economy of sustaining higher borrowing costs without pressure on the central bank to pause or reverse course.
Japan is moving away from a world in which low yields and a heavy central bank footprint in bond markets were taken for granted. That is why a rate hike can coexist with currency weakness: the market may be pricing uncertainty and a volatility premium, not merely the arithmetic of carry trades. Japan, in effect, is testing whether normalisation can proceed smoothly – and whether a durable exit from ultra-low rates reshapes inflation expectations without turning fiscal sensitivity into the dominant market narrative.
Seen this way, the common thread across Japan, Turkiye and Pakistan is not ‘rates up’ or ‘rates down’. It is credibility under constraint. In Turkiye, political interference weakened the tightening response and taught the public to expect accommodation, so the exchange rate moved first and risk premia followed. In Pakistan, the balance of payments repeatedly reasserts itself, and the exchange rate becomes the quickest channel from stress to prices, narrowing the corridor for easing. In Japan, the constraint is the transition itself: normalisation changes how markets price bonds and currencies and those expectations can overpower the simple textbook link between higher yields and a stronger currency.
The uncomfortable implication for public debate is that no economy can borrow another’s slogan. ‘High rates cause inflation’ is a caricature, and ‘tighten and the currency strengthens’ is not a law of nature. Monetary policy works through expectations, institutions and the channels that dominate a given economy – exchange-rate pass-through in externally constrained settings, risk premia and credibility in high-inflation regimes and fiscal sensitivity during normalisation in high-debt advanced economies.
The most important part of a rate decision is often not the number but what the public learns about the reaction function and whether the constraints around it are tightening or loosening.
The writer is a research fellow at the Sustainable Development Policy Institute (SDPI), Islamabad.
