Iran Conflict Escalates Inflation Concerns; Bank of Japan Faces Policy Dilemma Again

Amid the turmoil in Iran stirring financial markets and oil prices, the Bank of Japan faces a dilemma: should it pause interest rate hikes or continue to raise rates?

The escalation of tensions in the Middle East has driven up crude oil prices. The Bank of Japan was originally committed to achieving its 2% stable inflation target supported by wage growth and demand (rather than cost increases), but rising oil prices complicate this effort.

On one hand, soaring energy prices push up overall inflation, potentially providing a reason to raise interest rates; on the other hand, it could dampen consumer spending and pressure businesses, especially small firms already struggling with import costs.

If the Bank of Japan chooses to hold steady, considering political and economic growth concerns, it risks further weakening the yen, making energy imports more expensive. Conversely, if it continues to hike rates to curb inflation and strengthen the yen, it may stifle the fragile economic recovery.

The current situation mirrors the post-Russian-Ukrainian conflict scenario. Back then, surging import prices prompted major central banks, including the Federal Reserve and the European Central Bank, to quickly raise policy rates.

At that time, Japan was mired in deflation, implementing the world’s most accommodative monetary policy. The Bank of Japan was able to leverage this inflation wave to finally end its long-term quantitative easing program.

However, officials from the Bank of Japan say that the current environment is different. They aim to avoid misreading inflation signals and waiting too long to adjust rates.

Sources familiar with the decision-making process say that inflation expectations among Japanese businesses and households are finally beginning to form, and core price increases are approaching the Bank of Japan’s 2% target. The bank may no longer have much time to carefully consider its next move.

The insiders also note that despite geopolitical turmoil, Bank of Japan officials remain committed to raising rates. However, given ongoing financial market instability and the highly uncertain outlook for the Middle East, it will be difficult to take action at this week’s meeting.

Market expectations for a rate hike by the Bank of Japan this week are nearly zero, while the likelihood of a rate increase at the next meeting in April is about 60%. At that time, the bank will release its latest forecasts for economic growth and prices.

Another complicating factor is the Japanese government’s response to the Middle East crisis. Prime Minister Sanae Takaichi’s policy focus is firmly on economic growth, which suggests a preference for a loose monetary environment to ease supply shocks.

While the government is trying to buffer the impact on the real economy through gasoline subsidies and releasing oil reserves, it still faces a more systemic challenge: the persistent weakness of the yen.

Bank of Japan Governor Kazuo Ueda has acknowledged that, compared to the past, current exchange rate fluctuations are more likely to influence domestic prices, as companies have become more adept at passing increased costs onto consumers.

Daiwa Securities economist Kenji Yamamoto said, “If oil prices stay high or continue to rise, there’s a risk of a vicious cycle—worsening trade deficits leading to a weaker yen, which in turn further raises import prices.”

He added, “Imported inflation caused by a weak yen will accumulate over time, increasing the risk of rising prices. In the medium to long term, this raises the possibility that policy responses will lag behind the economic reality, effectively allowing inflation ‘magma’ to build up beneath the surface.”

Yamamoto expects the Bank of Japan to delay rate hikes until April, but he noted that given Takaichi’s inclination toward more easing, the pace of tightening may be slower than what economic fundamentals demand.

The economist said, “Whether the Bank of Japan hikes rates in April will likely be a turning point in market confidence in the bank’s continued tightening strategy.”