Japan's February CPI Falls Unexpectedly, but BOJ May Still Proceed with Rate Hike as Planned

Reuters Finance App — Japan’s February consumer price growth slowed further below expectations, but the Bank of Japan is likely to turn a blind eye to the recent slowdown in inflation and continue to focus on upside price risks.

Healthy wage negotiations and better-than-expected Purchasing Managers’ Index (PMI) data have increased the likelihood of a rate hike in April. However, the final decision still depends on developments in the Middle East.

Government utility subsidies led to a noticeable decline in February inflation

Japan’s consumer price index (CPI) rose 1.3% year-on-year in February, below January’s 1.5% and the market consensus, with a larger-than-expected slowdown. Fresh food prices fell 4.5%, utility prices dropped 5.5%, mainly driving the overall inflation decline. Seasonally adjusted, February CPI decreased 0.2% month-on-month. Goods prices fell 0.6%, while service prices rose 0.1%.

Despite actual inflation data being below expectations, the Bank of Japan is unlikely to place too much emphasis on this short-term slowdown, as it is mainly driven by government utility subsidies. The BOJ will focus more on the core inflation trend excluding food and energy prices. The “core-core” inflation rate in February slightly declined to 2.5% (from 2.6%), in line with market expectations, but remains significantly above the BOJ’s 2.0% target.

Overall inflation is expected to remain below 2% in the coming months, with core inflation remaining sticky

Although gasoline prices surged significantly, the impact of government fuel price caps is expected to keep the overall CPI year-on-year growth below 2% in the coming months. Meanwhile, base effects will continue to suppress inflation readings. However, core-core inflation is expected to stay around 2.5% with stickiness.

With positive early results from this spring’s wage negotiations, we believe demand-side inflation pressures will remain intact.

Initial wage negotiations are encouraging

Japan’s largest union federation, Rengo, announced an average wage increase of 5.26% this year, slightly below last year’s preliminary increase of 5.46%. This figure will be revised multiple times (such as on March 27 and April 3). Notably, the impact of the Middle East situation on wage negotiations has been very limited so far.

BOJ Governor Ueda previously emphasized that policymakers are closely monitoring whether wage increases can effectively cover small and medium-sized enterprises. Many SMEs will finalize wage agreements in April, making this dynamic a key market focus, with the final results expected before the BOJ’s April meeting.

PMI preliminary figures decline but remain in expansion territory

Japan’s March manufacturing PMI preliminary reading fell from 53 in February to 51.4, with declines in output and new orders. The services PMI also dropped from 53.8 in February to 52.8.

This decline mainly reflects recent global oil supply shocks and reduced new orders, raising concerns about economic outlook. However, both PMI indices remain above 50, indicating that companies generally view current geopolitical risks as temporary, and overall business confidence remains positive.

BOJ will ignore short-term inflation fluctuations and continue rate hikes

The BOJ will continue its rate hike process. The exact timing remains uncertain, expected between April and June, but we currently see a slightly higher chance of a rate hike in April than in June.

Sticky core inflation, better-than-expected PMI data, and a positive start to spring wage negotiations all increase the probability of a rate hike in April.

It is believed that developments in the Middle East will be a key variable in decision-making. If the situation stabilizes quickly and there are no clear signs of production or consumption slowdown, the likelihood of an April rate hike will further increase.

Overall, despite the February CPI data’s unexpected slowdown, the BOJ’s focus remains on the underlying inflation trend, wage growth sustainability, and economic resilience. As long as the Middle East situation does not worsen further and significantly drag down Japan’s economic activity, the probability of a rate hike in April remains relatively high. Market participants should continue to monitor wage negotiations and geopolitical developments.