The Bank of Japan is expected to flag the risk of dramatic shifts in underlying inflation when it publishes its quarterly outlook next month, according to former BOJ executive Kazuo Momma. He said the conflict in the Middle East has introduced unprecedented uncertainty into the central bank’s policy calculus.
Momma noted that prior to the Feb. 28 U.S.-Israeli strikes on Iran, the BOJ appeared positioned to resume tightening as soon as March or April. That trajectory has since been obscured by a surge in oil prices and disruptions to shipping through the Strait of Hormuz, he said.
Fading hopes for a quick end to the conflict now leave policymakers grappling with how an oil shock will transmit across global and domestic growth, inflation dynamics and corporate wage-setting. Those unknowns, Momma said, are likely to shape the BOJ’s upcoming quarterly report, which he expects will warn of two main risks.
Twin risks to be highlighted
First, the report will likely underscore the possibility that the Middle East conflict could dampen demand and weigh on the economy. Second, it will flag the danger that supply-side shocks tied to higher energy costs will fuel inflationary pressures.
"With so much dependent on Middle East developments, the BOJ probably won’t decide what to do with interest rates until the last minute," Momma said, referring to the prospect of a rate hike at the central bank’s next policy-setting meeting on April 27-28.
Momma, who keeps close contact with current policymakers, described the environment as "truly extraordinary times for central banking." He emphasized that the situation no longer lends itself to a simple policy formula based on a handful of economic variables, as may have been possible in the past.
Soaring oil prices tied to the conflict have complicated the BOJ’s decision on how quickly to resume raising rates after it lifted policy to 0.75% in December. Rising fuel costs add to inflationary pressure already present from a weak yen, but they also harm an economy that depends heavily on imported raw materials.
Market moves have reflected those tensions. The yield on five-year Japanese government bonds climbed to a new record high on Friday as the escalating conflict pushed inflation concerns higher and strengthened expectations for faster rate hikes by major central banks, including the BOJ.
Analysts and market participants are closely watching the BOJ’s quarterly outlook due at next month’s policy meeting for signals on how the Middle East conflict could alter the path for rate increases. Some analysts still see a chance of a hike to 1.0% in April.
"What the BOJ would be focusing on is not near-term spikes in gasoline and oil prices, but how underlying inflation could be behaving one, two years ahead," Momma said. He is currently an executive economist at private think tank Mizuho Research & Technologies.
Momma said the outlook for underlying inflation will depend on several factors that are difficult to forecast. These include the expected hit to global and Asian economies from oil supply disruptions and how companies set wages in next year’s annual negotiations.
Underlying inflation is already close to the BOJ’s 2% target, Momma noted. The additional price pressure from the Iran war could push inflation above that threshold, raising the risk of an overshoot.
"But it’s hard to say whether such inflationary risks are bigger than the risk of Japan sliding into recession," Momma said. "As a result, the BOJ would have to keep agonizing over what to do at each meeting."
The BOJ has stated that it will continue to raise rates if Japan makes progress in underlying inflation - defined as prices driven by domestic demand and wages - and if that progress is sustained at around 2%. To improve communication on underlying inflation, the BOJ recently began publishing a new index that strips out special factors; that series showed inflation at 2.2% in February.
Implications for markets and policy
The interaction between higher global energy prices, a weak yen and the pace of corporate wage increases will be central to the BOJ’s assessment of whether to press further on rates. With multiple moving parts and heightened geopolitical risk, the central bank’s decisions are likely to be incremental and made under significant uncertainty.