Japan's central bank has taken another major step away from the country's decades-long era of ultra-low interest rates.

The Bank of Japan raised its policy rate to 1.25% on Friday, the highest level in 31 years, in a widely anticipated decision aimed at preventing inflation from moving too far above the bank's 2% target.

The decision passed by a 7-2 vote, with board members Toichiro Asada and Ayano Sato dissenting.

On paper, the move should have supported the Japanese yen.

Higher Japanese interest rates generally make yen-denominated assets more attractive and can reduce the enormous interest-rate gap between Japan and countries such as the United States.

But the market reaction produced an unexpected result.

The yen weakened sharply.

The dollar rose to around 157.84 yen, with the Japanese currency falling roughly 1% after the decision. Reuters reported that the move reflected investor disappointment that the BOJ did not provide strong enough guidance about future rate increases.

That reaction reveals the real issue facing Japan.

The question is no longer simply whether the BOJ will raise rates.

It is whether investors believe the central bank will keep raising them.

The BOJ has been gradually moving away from its long-standing ultra-easy monetary policy.

For decades, Japan struggled with low inflation and weak domestic demand.

That environment encouraged extremely low interest rates and helped make the yen one of the world's most important funding currencies.

Investors could borrow cheaply in yen and invest elsewhere.

That trade helped shape global markets.

Now Japan is moving in the opposite direction.

Inflation has become more persistent.

Wage growth has strengthened.

Energy prices have increased.

And policymakers increasingly believe the economy is capable of tolerating higher borrowing costs.

The 1.25% rate therefore represents more than a single policy decision.

It is another marker in Japan's long transition toward a more conventional monetary-policy framework.

BOJ Governor Kazuo Ueda emphasized that future rate decisions will depend on economic data.

He said the central bank is watching inflation trends, wage growth and inflation expectations.

He also indicated that future increases, including larger or consecutive moves, remain possible if the economic outlook develops as expected.

That sounds hawkish at first.

But markets wanted something more concrete.

Investors had been looking for clearer guidance about how quickly rates might move toward what policymakers consider a more neutral level.

Instead, Ueda emphasized uncertainty.

The central bank still does not have complete confidence about the neutral rate.

It also needs to assess the impact of global energy prices, exchange-rate volatility and changes in the international economy.

That caution helped explain why the yen weakened.

Japan's inflation challenge is not identical to America's.

The United States has been dealing with strong domestic demand, services inflation and labor-market pressures alongside energy costs.

Japan has historically struggled with the opposite problem — insufficient inflation and weak demand.

That means policymakers do not want to tighten too aggressively.

The BOJ's goal is not simply to raise rates as high as possible.

It wants inflation to stabilize around 2% without damaging economic growth or causing financial conditions to become unnecessarily restrictive.

Ueda has emphasized the need to avoid a situation in which inflation overshoots substantially and then requires a much sharper correction.

That helps explain the gradual pace.

The currency's decline after a rate hike is a useful lesson in how foreign exchange works.

Markets trade expectations, not just current interest rates.

If a rate increase was already expected, the currency may have already priced it in.

What matters next is whether the policy path changes.

If investors expected three additional hikes and the BOJ signals caution, the yen can fall even after the central bank raises rates.

That appears to have been the reaction Friday.

Reuters reported that the presence of two dovish dissenters also raised questions about how much support exists inside the central bank for faster tightening.

The vote therefore contained two messages.

The majority wanted higher rates.

But there was still meaningful opposition.

Monetary policy does not operate independently of fiscal policy.

Japan's government has been discussing large-scale public and private investment plans, creating another source of demand in the economy.

That can complicate the BOJ's inflation calculations.

If fiscal policy remains expansionary while monetary policy tightens, the central bank may need to raise rates more than otherwise.

But higher rates also increase the government's borrowing costs.

Japan already has one of the world's largest government-debt burdens relative to the size of its economy.

That makes the interest-rate transition particularly delicate.

The U.S. Federal Reserve also raised rates this week, moving its policy range to 3.75%-4.00%.

That creates a significant interest-rate gap between Japan and the United States.

Even after Friday's BOJ hike, U.S. rates remain substantially higher.

That means investors still have a strong incentive to hold dollar assets.

The gap is one reason the yen remains under pressure despite Japan's tightening cycle.

The BOJ can narrow the difference gradually.

But it cannot eliminate it overnight.

Japan imports a significant share of its energy.

That means higher global oil prices can feed directly into domestic inflation.

Recent Middle East disruptions pushed crude above $100, creating additional pressure on Japanese consumers and businesses.

Ueda said rising energy costs remain one of the factors the BOJ is watching closely.

That creates another policy dilemma.

Higher oil prices can strengthen the case for tighter policy because inflation is rising.

But higher energy costs can simultaneously reduce household purchasing power and weaken economic growth.

The BOJ therefore has to distinguish between temporary energy-driven inflation and persistent domestic inflation.

Japan's monetary-policy transition would be much harder without stronger wages.

The BOJ wants evidence that price increases are being transmitted into wages and domestic demand.

If wages rise sustainably, households have more purchasing power.

Businesses can potentially continue raising prices.

Inflation becomes more self-sustaining.

That is a different environment from Japan's earlier decades of weak price growth.

Ueda has pointed to rising wages and inflation expectations as important developments supporting the central bank's current approach.

For global investors, the most significant development may be the end of the assumption that Japanese rates will remain extremely low forever.

That assumption influenced international capital flows for decades.

Japanese investors accumulated large holdings of U.S. and European bonds because domestic yields were so low.

Japanese financial institutions and investors also became important participants in global funding markets.

As Japanese yields rise, some of those capital flows could eventually change.

Even a gradual shift matters because Japan's financial system is enormous.

One reason global investors are watching the BOJ so closely is the possibility of capital repatriation.

If Japanese government bonds offer increasingly attractive yields, Japanese investors may decide to allocate more money domestically.

That could reduce demand for foreign bonds.

Higher Japanese yields could therefore contribute to upward pressure on U.S. Treasury and European government-bond yields.

The reverse is also possible.

If Japanese investors continue finding better risk-adjusted returns overseas, the impact could be limited.

That is why the BOJ's future path matters as much as Friday's decision.

Friday's market reaction demonstrates the importance of communication.

If Ueda signals that additional hikes are likely and the economy remains strong, the yen could regain ground.

If the BOJ remains cautious while the Federal Reserve stays relatively hawkish, the interest-rate gap could continue supporting the dollar.

Currency traders are therefore waiting for more information from the governor.

The exact wording around future tightening may matter as much as the current 1.25% rate.

Japan has historically intervened in currency markets when the yen becomes excessively weak.

Reuters reported that Finance Minister Satsuki Katayama has indicated Tokyo could act if necessary.

That introduces another layer of uncertainty for currency traders.

The BOJ controls monetary policy.

The Finance Ministry controls foreign-exchange intervention.

The government therefore has tools beyond interest rates to influence currency conditions.

But intervention is not a substitute for monetary-policy credibility.

Markets ultimately want to understand the long-term policy direction.

A 1.25% Japanese policy rate is historically significant.

It is the highest level in 31 years.

It demonstrates how far Japan's monetary environment has changed.

But the immediate market reaction shows that the level itself is not enough.

Investors want to know where rates go from here.

Will the BOJ keep tightening?

How quickly?

Will inflation stay near or above target?

Will wages continue increasing?

Will oil prices remain elevated?

And how large will the interest-rate gap with the United States become?

Those questions will determine the yen's next chapter.

For now, Japan has taken another step toward normalizing monetary policy.

The surprising part is what happened afterward.

The BOJ raised rates.

But the yen fell.

That is because currency markets were not waiting to see what Japan did today.

They were waiting for a signal about what Japan will do tomorrow.