By Leika Kihara
TOKYO, March 12 (Reuters) – Fresh supply shocks triggered by the Middle East conflict may speed up the Bank of Japan’s hawkish agenda by increasing inflationary risks, leaving open the chance of another rate hike as soon as April, say four sources familiar with its thinking.
The war, which is less than two weeks old, has unleashed economic chaos on the world, leaving global policymakers unsure whether to respond with restrictive or accommodative settings.
In Japan, the BOJ’s heightened attention to price risk marks a departure from its traditional focus on cushioning the blow to growth through low borrowing costs, highlighting its changing inflation dynamics.
To be sure, there is an equal chance the conflict could trigger a global downturn that hits Japan’s fragile recovery, and forces the BOJ to overhaul its rosy economic projections and rate-hike plans, the sources say.
The war in Iran could also give the government another reason to push back against an early rate hike with dovish premier Sanae Takaichi already said to hold reservations against further increases in borrowing costs.
Yet, rising crude oil prices are predominantly expected to boost inflation before they drag on growth, which means Japan will see an initial burst of inflationary pressure that could affect public price perceptions.
“The conflict comes at a time underlying inflation is already close to 2%,” requiring policymakers to be vigilant to the risk of higher inflation, said one of the sources, a view echoed by three more sources.
While the conflict has heightened economic uncertainty, that alone would not deter the BOJ from conducting necessary rate hikes, a fourth source said. The sources spoke on condition of anonymity as they were not authorised to speak publicly.
The Middle East conflict has not led to a sharp reduction in market bets of a near-term rate hike with an April move priced in by roughly 60%, suggesting investors, too, are increasingly focusing on upside risks to inflation.
THIS TIME MAY BE DIFFERENT
In the past, the BOJ would have looked through the impact of higher oil costs on inflation, and focused more on supporting a moribund economy, where households and firms – accustomed to decades of tepid price and wage growth – curbed spending.
That has led to a slow, cautious approach in withdrawing massive monetary support. It took two years from Russia’s invasion of Ukraine for the BOJ to exit a decade-long stimulus in March 2024, even as rising raw material costs pushed inflation above its 2% target.
While the central bank has since hiked rates to 0.75%, the slow pace has drawn criticism for pushing up import costs and broader inflation by keeping the yen weak.
This time, the BOJ may not be able to wait that long.
The conflict-driven fuel spike adds to rising import costs from a weak yen that has driven many firms to increase prices, and kept inflation above the BOJ’s target for nearly four years.
Rising prices have pushed up inflation expectations. Firms expect inflation to average 2.4% five years from now, while households project inflation of 9.8% for the same period, according to recent BOJ surveys.
After keeping wage growth stagnant for decades, a chronic labour shortage has prodded firms to boost wages including last year, when they agreed to the biggest pay hike in 34 years.
The mounting price pressure has led to growing calls within the BOJ board for steady rate hikes to avoid being behind the curve in containing the risk of too-high inflation.
“Medium- and long-term inflation expectations are heightening, and price increases now have a greater tendency to generate second-round effects,” hawkish board member Hajime Takata said on February 26, calling for steady rate hikes.
Speaking days after the February 28 U.S. attack against Iran, Governor Kazuo Ueda said the conflict could hurt the economy by worsening Japan’s terms of trade. But he also warned that it could push up underlying inflation.
Up until the U.S.-Israel attack on Iran, Japan’s economy had progressed towards meeting conditions for another rate hike with wage gains supporting consumption, the sources said.
While the BOJ is set to keep interest rates steady at next week’s policy meeting, Ueda is likely to repeat the bank’s resolve to continue raising rates and leave scope for near-term action at his post-meeting briefing, the sources say.
Underscoring its renewed focus on inflation, the BOJ published on February 4 an academic paper arguing that intensifying supply constraints had a “persistent impact” on prices, not just through actual increases but heightened inflation expectations.
Ayako Fujita, chief Japan economist at JPMorgan, expects the BOJ’s message next week to focus on maintaining “the normalization path” and “assess uncertainties related to the Iran war”.
“This would not pre‑commit to an April move while keeping the option open if conditions stabilise,” Fujita said.
While the conflict-driven market volatility will likely put the BOJ on hold until June or July, it will need to keep a close eye out on mounting price pressure, said the central bank’s former top economist Seisaku Kameda.
“The BOJ is already behind the curve in addressing mounting inflationary pressure,” he said. “The risk of being too late could heighten further with rising oil prices and the weak yen.”
(Reporting by Leika Kihara; Editing by Sam Holmes)
