The Bank of Japan (BOJ) is expected to maintain its warning that inflation could exceed its 2% target at next week’s monetary policy meeting, while signalling that the risks have not intensified significantly since its last economic assessment, according to three sources familiar with the central bank’s thinking.
In its quarterly outlook report due at the conclusion of the two-day policy meeting on July 31, the BOJ is expected to flag persistent inflationary pressures arising from the Middle East conflict, strong global demand driven by artificial intelligence, and higher import costs caused by the weak yen.
However, policymakers believe the likelihood of a worst-case inflation scenario—where severe supply disruptions trigger a sharp spike in prices and necessitate rapid interest-rate increases—has diminished compared with three months ago.
“There is a risk of underlying consumer inflation deviating upward from our 2% target,” the BOJ said in June when it raised interest rates, a warning that sources said is expected to be repeated in next week’s report.
The expected language reflects a shift from the bank’s April outlook, when it warned of a “big overshoot in inflation” amid heightened uncertainty following the Middle East conflict that erupted after the US-Israeli strikes on Iran on February 28.
Following that warning, the BOJ raised its policy interest rate to 1% in June, the highest level in 31 years.
With concerns over an immediate oil-driven inflation shock easing, the central bank is now focusing on whether businesses continue passing higher costs on to households, the sources said.
The shift suggests policymakers are looking beyond the direct impact of the Middle East conflict and concentrating on broader inflationary pressures, including AI-related demand and the persistent weakness of the yen, as they assess the timing of the next interest-rate increase.
Analysts surveyed by Reuters expect the BOJ to raise rates to 1.25% sometime between October and December.
“If prices rise in line with BOJ forecasts in the summer through autumn, that will lay the groundwork for the next rate hike,” said Mari Iwashita, a strategist at Nomura Securities.
The BOJ is widely expected to leave its benchmark interest rate unchanged at 1% next week while revising upward its economic growth forecast as uncertainty surrounding the Middle East conflict continues to ease.
Japan’s core consumer inflation stood at 1.6% in June, remaining below the BOJ’s 2% target for the fifth consecutive month, indicating that companies have yet to significantly pass higher production costs on to consumers.
Nevertheless, economists expect core inflation to climb above the 2% target later this year as rising producer prices gradually feed into consumer prices.
“Both upside price risks and downside economic risks appear to have subsided compared with three months ago,” one source said.
“The likelihood of the BOJ’s baseline projections materialising has increased,” another source added.
The sources spoke on condition of anonymity because they were not authorised to discuss the central bank’s deliberations publicly.
According to the sources, the BOJ is expected to retain its forward guidance indicating that it will continue raising interest rates while monitoring the economic and inflationary effects of the Middle East conflict.
However, policymakers remain divided over the pace of future tightening. More hawkish board members believe the BOJ has room to raise rates more quickly, while others advocate a more gradual approach.
The deciding factor could be stronger evidence that rising business costs are translating into sustained consumer inflation, a development that could prompt the central bank to tighten policy sooner than markets currently expect.
Some hawkish policymakers are also expected to push for bringing forward the BOJ’s projected timeline for achieving stable 2% inflation, which is currently forecast to occur between October this year and March 2028.
Analysts say that with inflation already close to the BOJ’s target, investors are becoming less focused on the projected timeline and more interested in the central bank’s assessment of inflation risks, financial conditions and the outlook for the yen.
“How the BOJ evaluates current financial conditions, including the ongoing depreciation pressure on the yen, will be important for gauging the timeline to the next hike,” said Ayako Fujita, chief economist at JPMorgan Securities Japan.
Boluwatife Enome
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