BOJ Signals Cautious Approach to Inflation Risks, Leaves Room for Rate Hike This Year

The Bank of Japan (BOJ) has signaled a cautious approach towards potential broadening price pressures that could lead to high inflation. Despite the possibility of a long pause before raising interest rates again, the bank has left room for action this year by expressing concern over the risks associated with rising prices.

Governor Kazuo Ueda emphasized that the BOJ's near-term focus is on downside risks to Japan's economy, particularly the impact of U.S. tariffs expected to intensify in the second half of this year. However, he also noted that there are upside risks to prices, and the bank should not rule out the possibility of rising food prices leading to sustained, broader-based inflation.

The escalating Middle East conflict has caused crude oil prices to surge, which Mizuho Securities expects to push up core consumer inflation by up to 0.2% point around autumn this year. This could heighten inflation expectations among households facing higher gasoline and utility bills, adding to already rising rice and food prices that have lifted headline inflation to 3.6% in April - well above the BOJ's 2% target.

Such price pressures might lead to an upgrade in the BOJ's price forecasts at its next quarterly outlook due on July 31. JP Morgan Securities economist Ayako Fujita expects the BOJ to revise up its price forecasts at the July outlook report, laying the path for a rate hike in October.

In its current forecasts made on May 1, the BOJ expects core consumer inflation to hit 2.2% in the year ending in March 2026 before slowing to 1.7% the following year. The estimates are based on the assumption that crude oil prices are broadly flat throughout the projection period and the effects of rising food prices wane.

U.S. trade policy uncertainty has complicated the BOJ's efforts to wean the economy off a decade-long stimulus, with initial plans to hike in July dashed by President Donald Trump's April tariff announcement. Some BOJ watchers saw Ueda's comments this week as surprisingly dovish and ruling out the chance of near-term rate hikes. Former BOJ board member Takahide Kiuchi said even if the BOJ resumes rate hikes, the next one will likely be around year-end or early next year, which would give the bank time to grasp the economic impact of Trump's tariffs.

The BOJ is paying particular attention to how rising food prices could affect households' inflation expectations. The doubling of the price of rice, a Japanese staple, has drawn intense public attention. "Price hikes are no longer scaring away consumers, which may be a sign households' inflation expectations are already heightening," a source familiar with the BOJ's thinking said. "If headline inflation stays around 4%, some in the BOJ might shift more in favor of rate hikes."

For now, the BOJ will likely stick to communication that leaves itself room to stand pat for as long as needed - or hike swiftly if uncertainty over U.S. trade policy clears up. This will likely keep market players guessing on the next rate-hike timing. Analysts at ING expect the BOJ to hold off raising rates until early 2026 if Japan's tariff negotiations with other countries progress favorably.