Japan's inflation continues to cool, making the Bank of Japan's path to raising interest rates increasingly complex.

Data released by the Ministry of Internal Affairs and Communications on Tuesday showed that the year-on-year increase in the Consumer Price Index (CPI) for February fell to 1.3%, the lowest level since March 2022, marking the fourth consecutive month of decline and falling below the Bank of Japan's 2% policy target.

Meanwhile, core CPI (excluding fresh food) rose by 1.6%, lower than the market expectation of 1.7%, and also fell below the 2% target for the first time in nearly four years.

The slowdown in inflation is mainly due to the drag from government fuel subsidy policies, but the surge in energy prices caused by the Middle East conflict presents a new upside risk, leading to greater uncertainty for the Bank of Japan in assessing inflation trends. Last week, the Bank of Japan maintained its benchmark interest rate at 0.75% while warning of the upside risks to inflation posed by the situation in the Middle East.

Core Inflation Falls Below Target, Making Timing of Rate Hikes Harder to Grasp

Core CPI rose 1.6% year-on-year in February, down from 2.0% in January, falling below the Bank of Japan's 2% target for the first time since March 2022 and missing economists' forecasts of 1.7%.

Core CPI excluding fresh food and energy rose 2.5% year-on-year, a slight decrease from 2.6% in January. The Bank of Japan views this indicator as a better reference for demand-driven inflation.

According to Reuters, analysts expect core CPI to remain below 2% in the coming months due to the ongoing impact of government fuel subsidies. The gasoline price control measures introduced by the government this month are estimated by analysts to potentially lower core CPI by as much as 0.5 percentage points.

Bank of Japan Governor Kazuo Ueda has previously stated that the bank is prepared to continue raising interest rates if it becomes more confident that underlying inflation will stabilize around the 2% target. Last week, he also mentioned that the central bank will announce a new price index by this summer, excluding the effects of one-off policy measures such as fuel subsidies, to more accurately gauge underlying inflation trends—some analysts interpret this move as an attempt to provide a basis for further rate hikes.

Government Policies and Energy Shocks: Dual Disturbances to Inflation Trends

The cooling inflation is driven behind the scenes by active government intervention. Prime Minister Sanae Takaichi pledged during her campaign to suspend the 8% food tax for two years, and the government has also introduced multiple measures to alleviate the pressure of living costs on residents, including fuel subsidies, which while suppressing inflation data, also make it difficult for the Bank of Japan to accurately assess the level of underlying inflation.

The Bank of Japan previously projected that consumer prices might fall below 2% in the first half of this year due to the aforementioned policies. The bank's forecasts for core CPI and core-core CPI for fiscal year 2026 (starting April 1) are 1.9% and 2.2%, respectively.

Simultaneously, the energy price shock stemming from the Middle East conflict poses a counteracting pressure. According to CNBC, Stefan Angrick, Moody's Analytics' chief economist for Japan and frontier markets, called the Middle East conflict an "unsettling surprise." He noted that surging commodity prices could trigger supply shocks and push up inflation, which is "bad news for importers of energy and food like Japan." He also pointed out that if the conflict ends relatively quickly, the impact on the economy may be limited, but if the fighting persists, the blow will be more severe.

Weak Economic Growth Increases the Difficulty of Policy Trade-offs

The combination of slowing inflation and weak economic growth further constrains the Bank of Japan's policy options. Data shows that Japan's economy grew by only 0.1% year-on-year in the fourth quarter of last year, a significant slowdown from the 0.6% growth in the third quarter, narrowly avoiding a technical recession.

The Bank of Japan ended its decade of ultra-loose monetary policy in 2024 and has raised interest rates multiple times, including a hike in December last year, citing steady progress in Japan's sustained achievement of the 2% inflation target. However, the continued decline in current inflation data has made markets more cautious in assessing the timing of the central bank's next rate hike.

The Japanese government's various price intervention measures continue to distort inflation data, posing a greater challenge for the central bank in gauging underlying inflation trends. Governor Ueda's introduction of a new price index is interpreted by some analysts as an attempt by the central bank to find clearer grounds for rate hikes amidst policy noise.