Bank of Japan staff said in a policy paper released on Monday that underlying inflation in Japan - the measure focused on price growth driven by domestic demand rather than external cost shocks - may be more vulnerable to upward pressure from rising crude oil prices and declines in the yen than it was previously.
The BOJ noted that while a recent rise in crude oil could weigh on the economy, it also has the potential to lift public inflation expectations and thereby push up underlying inflation. The paper emphasizes the interaction between external cost pressures and evolving corporate behaviour.
"Attention is warranted to the possibility that upward pressure on prices through this channel may have strengthened compared with the past," the paper said, pointing to firms becoming more proactive in raising prices and wages. That change in price-setting behaviour, the BOJ warned, could make underlying inflation more sensitive to yen depreciation because a weaker currency raises the local cost of imports.
The staff analysis also highlighted that even transitory supply-side developments can influence expectations. "Even temporary supply-side factors may affect inflation expectations," the paper said, noting that recent food price increases, if they prove persistent, could place ongoing upward pressure on overall consumer inflation.
The publication offers context for the BOJ's shift in policy last year when the central bank wound down its decade-long, massive stimulus programme and began raising short-term interest rates in 2024 on the view that Japan was approaching a durable achievement of its 2% inflation objective. The BOJ has said it will continue to raise rates if it becomes more convinced that underlying inflation will be stable at 2%.
Responding to critiques that its notion of underlying inflation has been insufficiently precise, the BOJ set out the methods it uses to identify price trends. In addition to monitoring the output gap, the central bank examines a range of price indicators, including a newly disclosed index that removes one-off elements such as government subsidies, and applies economic models to assess momentum in prices.
Surveys also play a role in the BOJ's assessment. The staff said it reviews multiple survey measures of public expectations and compiles composite indices. Those indices currently indicate inflation expectations in a band between 1.5% and 2.0%, according to the paper.
On domestic conditions, the BOJ noted that the output gap has been improving over time, albeit with fluctuations, while labour market tightness remains pronounced and wages are rising moderately. "Looking at factors underlying price developments, the output gap has been on an improving trend, albeit with some fluctuations. Labor market conditions remain extremely tight, and wages are rising moderately," the paper said.
Taking these elements together, the BOJ judged that "the underlying inflation rate is rising moderately toward 2%." The staff cautioned that, from the perspective of achieving price stability in a sustainable and stable way, it will be important to monitor whether underlying inflation becomes firmly anchored at around the 2% level.