Japan’s demand-led inflation slows, clouds BOJ rate hike path

According to data released on Friday, Japan’s core inflation increased in May, primarily driven by energy levies. However, the index that excludes the impact of fuel has slowed for the ninth consecutive month. This poses a challenge for the central bank in determining when to raise interest rates.

The deceleration in “core core” inflation, which is closely monitored by the Bank of Japan as a crucial indicator of demand-driven price movements, raises doubts about the bank’s belief that rising wages will support consumption and lead to sustained inflation reaching its 2% target.

Government data revealed that the core consumer price index (CPI), which excludes volatile fresh food, rose by 2.5% in May compared to the previous year. This was an acceleration from the 2.2% gain in the previous month, largely due to an increase in the renewable energy levy. The figure was in line with the market’s median forecast of a 2.6% gain.
In May, inflation, excluding fresh food and fuel, decreased to 2.1% from 2.4% in April, the lowest year-on-year increase since September 2022.

The inflation rate for private-sector services also slowed down to 2.2% in May from 2.4% in the previous month. This suggests that companies are still cautious about passing on labor costs.

Marcel Thieliant, head of Asia-Pacific at Capital Economics, commented that the Bank of Japan has been expecting the recent pay hikes from spring wage negotiations to eventually boost services inflation. However, there is currently little evidence of this happening.

The outlook for inflation is further complicated by a renewed rise in crude oil prices and the impact of a weak yen on import costs.
According to analysts, there is an expectation for core CPI to increase to around 3% later this month due to the rise in raw material costs. However, this could potentially have a negative impact on consumption and discourage companies from raising prices. As a result, this could hinder the Bank of Japan’s efforts to maintain a sustainable 2% target for underlying, demand-driven inflation.

Takeshi Minami, the chief economist at Norinchukin Research, stated that real wage growth in Japan remains weak and there is no data confirming an acceleration in demand-driven inflation. He believes that the Bank of Japan is unlikely to raise rates again until at least October-December this year.

In a significant shift away from a decade-long radical stimulus program, the Bank of Japan exited negative rates and bond yield control in March. With inflation surpassing its 2% target for the past two years, the bank has hinted at the possibility of raising short-term rates to a level that neither cools nor overheats the economy, estimated by analysts to be somewhere between 1-2%.
As per the views of economists, it is anticipated that the Bank of Japan (BOJ) will increase interest rates to 0.25% sometime this year, although there is disagreement on whether this will happen in July or later in the year.

BOJ Governor Kazuo Ueda has stated that the central bank will only raise rates if it becomes more confident that inflation will consistently reach 2%, driven by strong domestic demand and higher wages.

However, there are concerns due to recent signs of weakness in consumption. In the first quarter, Japan’s economy contracted, partly due to a 0.7% decline in consumption. Rising living costs have deterred households from increasing their spending, which is a cause for worry.