According to a former chief economist of the Bank of Japan, the war in Iran has heightened the risk of inflation rising, which provides grounds for the Bank of Japan to raise interest rates as early as this month.
“If the aim is to assess the situation, I think it’s fine to take action in April,” former chief economist Toshitaka Goto said in an interview on Wednesday. “By the end of April, we can at least know whether the impact of the situation in the Middle East will be short-lived.”
Although commentators are still debating whether geopolitical shocks will cause inflation or deflation in a resource-poor country like Japan, Kawanishi’s remarks suggest that the Bank of Japan may be more convinced of the need to raise interest rates when it formulates policy on April 28.
Kanai, who worked at the central bank for more than three decades until 2020, speculated that Bank of Japan officials might share his view, as the summary of the March policy meeting clearly indicated that council members were increasingly concerned about inflation risks.
Kanai said that the conflict in Iran is bound to cause a supply shock and push up inflation. Previously, Japanese households have faced price hikes above the Bank of Japan’s 2% target for four consecutive years. The Cabinet Office estimates that a 10% increase in oil prices will raise the inflation rate by 0.3 percentage points. Since the outbreak of the war, oil prices have risen by about 50%.
Traders believe that the possibility of the Bank of Japan raising interest rates at its meeting this month is about 70%. However, many observers of the Bank of Japan point out that the final decision will depend on the development of the situation in the Middle East, as Governor Kikuo Iwata has promised to closely monitor the upside and downside risks to inflation.
“I think the upside risk is greater,” said Sekine, adding that Prime Minister Kōno Ema has already increased spending to control living costs and is likely to introduce more measures. He pointed out that this, in turn, could create inflationary pressure from a fiscal perspective.
Kuroda has indicated her preference for a gradual approach to raising interest rates. What is now crucial is whether the prime minister will make efforts to prevent borrowing costs from rising amid an uncertain economic outlook.
Kaneko said that if the Bank of Japan fails to fulfill its responsibility of stabilizing inflation due to political factors, the cost could be extremely high, as financial markets might react strongly.
“If this situation occurs, it is highly likely that foreign investors will sell off the yen in large quantities, leading to further depreciation of the yen,” said Sekine. “Coupled with the rise in crude oil prices, this will exert greater upward pressure on inflation, pushing it to a worrying level.”
UBS strategists said that despite the increased intervention by Japanese officials, the downward trend of the yen will continue. They believe that in a “prolonged period of volatility”, the USD/JPY exchange rate will reach 175 by the end of the year.
Strategists such as Shahab Jalinoos noted in a report released on Wednesday that if oil prices rise to around $150 per barrel, “attempts to control inflation through foreign exchange intervention could lead to the market selling the yen at higher prices, thereby depleting foreign exchange reserves without necessarily changing the oil price trend.” They added that efforts to curb inflation might be better placed on fiscal measures such as energy subsidies.
In this situation, the market may believe that in a global stagflationary environment, Japanese policymakers do not intend to prevent the yen from weakening, and the resulting trade condition shock will drive the USD/JPY to strengthen significantly.
