The Bank of Japan is on guard against upside inflation risks that, if realised, could lead to rate increases at a faster clip than market consensus, according to three people familiar with the central bank's internal thinking.
Those officials argue the pace and timing of future hikes should not be pre-committed but must respond to incoming economic and price data. Several policymakers, the sources said, believe that any decisions about raising policy rates will hinge on how inflation and the broader economy evolve rather than on a fixed schedule.
At the same time, some within the BOJ see room to tighten policy more quickly than the prevailing market view of about two hikes a year, the sources added. Their concern is that price pressures stemming from a weaker yen and rising fuel costs linked to the U.S.-Israeli war on Iran could accelerate inflation beyond current expectations.
"Companies are passing on rising costs at a pretty steady pace and inflation expectations are heightening, which needs to be taken into account in setting policy," one source said. Another source echoed that assessment, noting the transmission of import costs into domestic prices is occurring with noticeable speed.
A third source said the central bank's meetings in September and October could be live for a potential rate move, depending on the degree to which firms continue to raise prices over the summer to offset higher costs.
The three sources spoke on condition of anonymity because they were not authorised to speak publicly. Market moves reflected those reports: the yen and short-term Japanese government bond yields climbed after Bloomberg News published an item earlier on Wednesday suggesting BOJ officials are open to tightening faster than many economists expect.
The BOJ raised its policy rate to 1% in June, the highest level in 31 years. Ahead of that decision, a Reuters poll conducted before the June move showed many analysts had expected the BOJ to push rates to 1.25% by the end of the year.
ATTENTIVE TO RISKS
The central bank is widely expected to hold its policy rate at 1% at next week's meeting. Officials will also publish fresh quarterly projections that could provide signals about the likely timing of the next rate increase.
Sources told Reuters the BOJ may lift its growth forecast for fiscal 2026 in the new projections while maintaining a strong focus on the risk of an inflation overshoot. They said rising import costs driven by a weak yen and strong demand for AI-related investment have offset part of the recent decline in oil prices.
In April's report, the BOJ had highlighted both downside risks to growth and a possibility of inflation sharply overshooting its 2% target, a risk it linked to the U.S.-Israeli war on Iran. Although those risks have eased somewhat since April, the chance of an inflation overshoot persists as companies more quickly pass through rising import costs, the sources said.
Robust global demand related to AI is putting upward pressure on prices for metals and semiconductor chips, the sources added. Those cost increases are likely to feed through into broader consumer goods prices, contributing to persistent underlying inflation that is already close to the BOJ's 2% objective.
Given that underlying inflation is near target, even modest additional inflationary impulses would draw heightened attention from policymakers when deciding the timing of future rate steps, the sources noted.
Analysts say the BOJ could face pressure to convey a hawkish tilt at the upcoming policy meeting as the yen sits at a 40-year low, a condition partly driven by expectations that the interest-rate gap between the United States and Japan will remain wide.
BOJ officials have stressed they do not directly target exchange rates when setting monetary policy, but they have also said they are closely monitoring yen moves because weaker currency swings now have a more pronounced effect on domestic inflation than in the past.