The Bank of Japan "doves hiding hawks": pauses interest rate hikes but warns of rising inflation risks, possibly laying the groundwork for action in October

According to the Zhitong Finance APP, although the Bank of Japan may maintain a wait-and-see approach for a long time before raising interest rates again, its cautious statement regarding the increasing inflationary pressures still leaves room for action this year, as these pressures may give rise to the risk of excessively high inflation.

Despite investors focusing on the dovish decision to slow down the reduction of bond purchases at this week's Bank of Japan policy meeting, the Bank of Japan also provided several reasons to suggest that it should continue to push for interest rate hikes. Bank of Japan Governor Kazuo Ueda stated on Tuesday that the recent focus is on addressing the downside risks to the Japanese economy, particularly the intensified impact of U.S. tariffs in the second half of this year, implying that the Bank of Japan is not in a hurry to resume interest rate hikes.

However, Ueda also pointed out that there are not only downside risks to prices but also upside risks, adding that the Bank of Japan should not rule out the possibility of rising food prices leading to sustained and broader inflation. He stated, "If tensions between Iran and Israel continue, the resulting fluctuations in oil prices, combined with already rising food prices, could affect inflation expectations and potential inflation. Therefore, we must closely monitor developments."

Ueda's remarks come at a time when tensions in the Middle East are escalating, leading to a surge in crude oil prices. Mizuho Securities expects that the recent rise in fuel costs will push Japan's core CPI up by as much as 0.2% around this fall, potentially raising inflation expectations for households facing higher gasoline and utility bills.

This will exacerbate the already rising inflation trend driven by rice and food prices. Data shows that Japan's overall inflation rate rose to 3.6% in April, far exceeding the Bank of Japan's target of 2%. This price pressure may lead the Bank of Japan to raise its inflation expectations in the next quarterly outlook report to be released on July 31, when the monetary policy committee will reassess whether cost-push inflation is easing as expected.

Currently, the Bank of Japan forecasts that the core CPI will reach 2.2% in the year ending March 2026, before slowing to 1.7% in the following year. These forecasts are based on the assumption that crude oil prices will remain roughly stable throughout the forecast period and that the impact of rising food prices will diminish.

JP Morgan Securities analyst Ayako Fujita stated, "We expect the Bank of Japan to raise its inflation expectations in the July outlook report, paving the way for an interest rate hike in October."

Complex Situation

The uncertainty of U.S. trade policies complicates the Bank of Japan's efforts to exit a decade-long stimulus policy, with plans for a rate hike in July being shelved due to Trump's announcement in April of large-scale tariffs on trade partners. If Japan's economic growth slows due to trade and other factors, the Bank of Japan may have to pause interest rate hikes to avoid putting greater pressure on the domestic economy.

Some observers of the Bank of Japan believe that Ueda's remarks this week were unexpectedly dovish, ruling out the possibility of a near-term rate hike. Former Bank of Japan monetary policy committee member Takahide Kiuchi stated that even if the Bank of Japan resumes interest rate hikes, the next hike may not occur until the end of this year or early next year, allowing the Bank of Japan time to assess the impact of Trump's tariffs on the economy Nevertheless, the Bank of Japan has recently intensified its warnings about the second-round effects of supply shocks, as it becomes increasingly concerned about falling behind in addressing the risks of excessively high inflation. In its outlook report on May 1, the Bank of Japan pointed out that rising rice and food prices could influence potential inflation by altering the public's perception of future price changes. In the strongest warning yet regarding inflationary pressures, Kazuo Ueda stated last month that Japan is experiencing "a new round of supply shocks," specifically manifested in rising food prices, which may require a policy response. He noted, "Given that potential inflation is closer to 2% than it was a few years ago, we need to carefully observe how food price inflation will affect potential inflation." He added that ignoring the impact of raw material prices poses risks.

The Bank of Japan is particularly concerned about how rising food prices will affect households' inflation expectations. The doubling of rice prices, a staple in Japan, has drawn significant public attention. A source familiar with the Bank of Japan's thinking stated, "General consumers are no longer deterred by price increases, which may indicate that households' inflation expectations have already risen." Another source mentioned, "If the overall inflation rate remains around 4%, there may be more support for interest rate hikes within the central bank."

Currently, the Bank of Japan may continue to maintain a communication strategy that preserves space for keeping interest rates unchanged for an extended period while also leaving the possibility for a rapid rate hike after uncertainties regarding U.S. trade policy are resolved.

This strategy may continue to fuel market speculation about the specific timing of the next interest rate hike. Analysts at ING expect that if Japan's tariff negotiations with the U.S. are more prolonged than anticipated, the Bank of Japan may delay raising rates until early 2026. However, analysts also added that if potential inflationary pressures intensify, the timing of the rate hike could be moved forward. Analysts stated, "The earlier increases in rice and food prices have already transmitted to service prices and other manufactured goods prices. We also see that rents are expected to gradually rise in the coming months." "If core inflation continues to stay above 2% in the next few months, the Bank of Japan may still raise rates in the fourth quarter of 2025."