Japan Warns of Accelerating Cost Pass-Through Inflation as BOJ Expected to Maintain Rates

Japan's Cabinet Office has issued its annual white paper, indicating that companies are increasingly transferring rising costs from the ongoing Middle East conflict to consumers at a pace faster than during the energy shock caused by the Ukraine war in 2022. This development contributes to a growing consensus that inflationary pressures in Japan are becoming more persistent, a view echoed by the Bank of Japan (BOJ).

The white paper notes that both corporate and household inflation expectations are on the rise, reinforcing the BOJ's perspective that price pressures are becoming embedded after years of deflation. Despite these challenges, the report maintains a resilient outlook on the economy, highlighting that corporate investment plans have surpassed historical averages for two consecutive years.

However, the report also cautions that the potential economic impact of the conflict warrants close monitoring, particularly regarding its effects on growth and the widening output gap.

Recent data supports these findings: June's core Consumer Price Index (CPI) rose by 1.6% year-on-year, matching forecasts and up from 1.4% in May. Meanwhile, the core-core CPI, which excludes fresh food and energy, eased to 1.7%, marking its slowest annual pace since August 2022. Additionally, flash Purchasing Managers' Index (PMI) data for July revealed that service sector inflation is at its highest level in over 12 years, even as overall input cost inflation has eased to a three-month low.

The white paper, compiled under Economy Minister Minoru Kiuchi, who is perceived as cautious regarding the BOJ's rate hike trajectory, adds a layer of complexity to the central bank's messaging ahead of its next meeting on July 30-31. While the BOJ is widely expected to maintain its current interest rates, the report's inflation warnings suggest a growing case for potential tightening in the future.

In summary, the combination of the Cabinet Office's warning on cost pass-through, this week's CPI data, and the PMI findings indicates that while the BOJ may hold off on immediate action, the backdrop for future policy adjustments is becoming increasingly compelling.