Iran Situation Pushes Up Inflation, Bank of Japan Faces Familiar Policy Dilemma

The Iran situation and conflicts are disrupting financial markets and oil prices. The Bank of Japan is once again faced with a familiar dilemma: pause policy adjustments or continue raising interest rates.

The escalating tensions in the Middle East have pushed up crude oil prices, making it more difficult for the Bank of Japan to achieve its policy goals. The bank aims for a stable 2% inflation driven by wage growth and demand, not cost-push factors.

Rising energy prices can boost overall inflation, seemingly justifying rate hikes, but they may also dampen consumer spending in Japan and increase pressure on businesses, especially small and medium-sized enterprises already burdened by import costs.

If the Bank of Japan remains on hold to consider political and economic growth, it risks further yen depreciation, which would raise energy import costs. Conversely, raising interest rates to curb inflation and support the yen could disrupt the fragile economic recovery.

The current situation resembles the post-Russian-Ukrainian conflict scenario: at that time, import prices surged sharply, prompting major central banks like the Federal Reserve and the European Central Bank to quickly hike rates.

Back then, Japan was mired in deflation and implemented the world’s loosest monetary policy, which allowed it to leverage rising inflation to eventually exit its long-standing quantitative easing policy.

However, the Bank of Japan’s decision-makers now say the environment has changed and aim to avoid misjudging inflation signals or delaying rate adjustments.

Sources familiar with the decision-making process reveal that inflation expectations among Japanese businesses and households are finally taking shape, with core inflation approaching the Bank’s 2% target. The Bank of Japan no longer has much time to calmly plan its next move.

Despite geopolitical turmoil, Bank of Japan officials still lean toward continuing rate hikes, but given ongoing market instability and the high uncertainty in the Middle East, no action is likely at this week’s meeting.

Market expectations currently put the probability of a rate hike this week at nearly zero, with about a 60% chance of a hike at the next meeting in April, when the bank will also release its latest economic growth and inflation forecasts.

Another complicating factor is Japan’s government response to the Middle East crisis. Prime Minister Fumio Kishida’s policy focus is on economic growth, favoring a loose monetary environment to ease supply shocks.

While the Japanese government has mitigated impacts on the real economy through gasoline subsidies and releasing oil reserves, the persistent weakness of the yen remains a systemic challenge.

Bank of Japan Governor Kazuo Ueda has acknowledged that as companies are more willing to pass increased costs onto consumers, exchange rate fluctuations now have a more direct impact on domestic prices than in the past.

Daiwa Securities economist Kenji Yamamoto states, “If oil prices stay high or continue rising, a vicious cycle could occur—worsening trade balances leading to further yen depreciation, which in turn raises import prices.”

Yamamoto notes, “The imported inflation driven by yen depreciation will continue to pose upward risks. In the medium to long term, this could increase the likelihood of delayed policy responses, effectively causing inflation ‘magma’ to accumulate underground.”

He expects the Bank of Japan to raise rates again in April, but given Prime Minister Kishida’s inclination toward easing monetary policy, the pace of tightening may lag behind what the economic fundamentals require.

Yamamoto concludes, “Whether the Bank of Japan can successfully hike rates in April may become a turning point that determines market confidence in its subsequent tightening policies.”