Tokyo—For the first time in five months, core inflation in Japan’s capital city of Tokyo fell below the Bank of Japan’s (BOJ) 2% target, raising concerns about the central bank’s ability to justify further interest rate hikes. The Tokyo core consumer price index (CPI), which excludes volatile fresh food costs, rose by 1.8% in October 2024 compared to the same period last year, marking a slowdown from September’s 2% increase. This deceleration has added complexity to the BOJ’s ongoing efforts to normalize its ultra-loose monetary policy amidst global inflationary pressures.

The Tokyo CPI is a closely monitored gauge, often seen as a bellwether for national inflation trends. Despite exceeding the median market forecast of 1.7%, the dip in core inflation has cast doubts over the BOJ’s inflation outlook and the central bank’s expectations of a sustained inflationary trend driven by higher wages. Moreover, service-sector inflation, another critical area of focus for the BOJ, slowed to 1.1% in October from 1.2% in September. This further complicates the central bank’s objectives, as the anticipated wage-driven inflationary pressures are not as widespread as initially projected.

BOJ’s Inflation Struggle and Policy Impact

The Bank of Japan, led by Governor Kazuo Ueda, has maintained an accommodative monetary policy for years, primarily aiming to achieve a stable inflation rate of 2%. This goal has been elusive, and the central bank has had to navigate through a mix of factors, including global supply chain disruptions, rising energy costs, and more recently, weakening domestic demand. Governor Ueda had previously signaled that the BOJ might consider further interest rate hikes if inflation remained on track to meet or exceed the 2% target. However, the latest Tokyo inflation figures complicate this scenario.

“The recent data is disappointing for the BOJ, as price hikes reflecting rising labor costs are not broadening enough in the service sector,” noted Saisuke Sakai, a senior economist at Mizuho Research & Technologies. “This could signal a cautious approach to their price outlook and may force the BOJ to rethink its strategy.”

The BOJ has been closely monitoring service-sector inflation, particularly because wages and services tend to be stickier sources of inflation. If wage growth and service prices rise, it could indicate a more sustainable inflationary trend, which would justify further tightening. However, the current slowdown in services inflation suggests that businesses remain hesitant to pass on rising costs to consumers, likely due to a still-weak consumption outlook.

Factors Influencing October’s Inflation Dip

Several temporary factors have contributed to the softening inflation rate in October. The Japanese government’s resumption of subsidies aimed at curbing utility bills played a key role in suppressing core inflation, while a shortage of rice—one of the nation’s staple foods—pushed up prices, impacting the core-core index. The core-core CPI, which excludes both fresh food and fuel costs and is considered a more accurate indicator of underlying price trends, rose by 1.8% in October, up from 1.6% in September. While this uptick might seem promising, it is insufficient to alleviate concerns over the overall deceleration.

According to Takeshi Minami, chief economist at Norinchukin Research Institute, the latest data is unlikely to derail the BOJ’s long-term plans for policy normalization. “We continue to expect the BOJ to at least discuss another rate hike in December,” Minami said. However, the central bank may be forced to adopt a more cautious approach if the trend of weak inflation persists.

Global and Domestic Pressures on Japan’s Inflation

Japan’s inflationary environment has been shaped by both external and domestic factors. Globally, inflation has surged in major economies, driven by post-pandemic recovery, supply chain bottlenecks, and rising energy prices. While Japan has also faced higher import costs, particularly due to a weaker yen, its domestic inflation dynamics have remained more subdued compared to peers like the United States and the Eurozone.

Japan’s unique economic structure, characterized by low wage growth and an aging population, has contributed to this difference. Although the BOJ had hoped that wage increases negotiated in the spring labor talks would lead to a more sustained inflationary trend, the results have been mixed so far.

The slow uptake of wage-driven inflation in the service sector has been particularly disappointing. Businesses in non-public sectors have been reluctant to raise prices in response to higher labor costs, suggesting that consumption is not strong enough to absorb such increases. “This hesitancy among businesses reflects the still-fragile nature of Japan’s consumer demand,” said Norinchukin’s Minami. “While the BOJ anticipated gradual rises in services prices, it seems consumption has not yet caught up.”

Economic Forecasts and Implications for Monetary Policy

The October inflation data will be a crucial factor in the BOJ’s next policy meeting, where the central bank is expected to release updated quarterly growth and price forecasts. Economists and market analysts are divided on the central bank’s next move. A slim majority of economists polled by Reuters believe the BOJ will forgo another rate hike this year, but most expect a rate increase by March 2025 if inflationary pressures continue to build.

The BOJ’s policy decision will also be influenced by global economic conditions, particularly in the U.S. and Europe. Both the Federal Reserve and the European Central Bank have adopted aggressive rate-hiking strategies to combat inflation, and their actions could spill over into Japan’s economy, impacting trade and investment flows.

However, Japan’s domestic economy remains vulnerable to slow growth. Although the country has seen a modest recovery from the pandemic, structural challenges such as stagnant wages, an aging workforce, and low productivity growth continue to weigh on the economy. These factors may limit the BOJ’s ability to raise rates aggressively without risking a further slowdown.

Potential Long-Term Scenarios for the BOJ

In the long term, the BOJ faces a delicate balancing act between fostering economic growth and controlling inflation. If inflation remains below the 2% target, the central bank may be forced to delay further rate hikes, extending its already lengthy period of monetary accommodation. On the other hand, if wage growth and consumer spending pick up in the coming months, the BOJ could have a stronger case for policy normalization.

One possible scenario is that inflation remains volatile, with temporary factors such as government subsidies and supply chain disruptions causing fluctuations in the CPI. In this case, the BOJ may opt for a more gradual approach to rate hikes, closely monitoring domestic demand and global economic conditions.

Another scenario is that inflationary pressures intensify due to a weaker yen and rising import costs. This could push the BOJ to accelerate its policy tightening, although the risk of a policy-induced economic slowdown would remain a significant concern.

Conclusion: Uncertainty Ahead for the BOJ

As the BOJ prepares for its upcoming policy meeting, the latest inflation data has highlighted the ongoing challenges facing Japan’s economy. While inflation remains above pre-pandemic levels, it has not yet stabilized at the BOJ’s 2% target. The slowdown in core inflation, particularly in the service sector, underscores the difficulty of achieving sustained price increases in an economy characterized by weak domestic demand and slow wage growth.

In the months ahead, the BOJ will need to carefully navigate these challenges as it considers further rate hikes. The outcome of the central bank’s policy decisions will have significant implications for Japan’s economic recovery, as well as for its position in the global economy. For now, the path forward remains uncertain, with both risks and opportunities on the horizon for the world’s third-largest economy.

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Photo source: Google

By: Montel Kamau

Serrari Financial Analyst

25th October, 2024