Japan's Inflation Slows, But Rate Hike Expectations Persist

Food products are displayed for sale in a supermarket in Tokyo. Japan's core inflation, excluding volatile fresh food prices, showed a second consecutive monthly slowdown in July, yet still remained above the Bank of Japan's (BOJ) 2% target. This persistent inflationary pressure is keeping alive market expectations for a further interest rate increase in the coming months.

The nationwide core consumer price index (CPI) rose 3.1% in July compared to the previous year. This increase, while lower than the 3.3% rise observed in June, still indicates ongoing inflationary pressures. The deceleration is largely attributed to the base effect of last year's energy price increases, which resulted from the end of government subsidies designed to curb fuel costs.

Economist Kazutaka Maeda of Meiji Yasuda Research Institute anticipates a continued easing of inflation throughout the year, driven by a moderation in rice price surges and the reinstatement of energy subsidies. Despite this, inflation remains elevated, and the current price environment supports the case for the BOJ to consider raising interest rates, potentially as early as October.

Energy prices saw a 0.3% decrease, the first year-on-year drop since March of the previous year. However, food inflation, excluding volatile fresh products, accelerated, suggesting that rising living costs continue to strain Japanese households. A separate index, closely watched by the BOJ as a measure of domestic demand-driven prices, which excludes both fresh food and fuel costs, also rose, indicating persistent price pressures.

Elevated food and raw material costs have kept Japan's core inflation above the BOJ's 2% target for an extended period, prompting concerns among some policymakers about potential secondary price effects. The BOJ ended a period of massive stimulus last year and raised short-term interest rates, reflecting a shift towards normalizing monetary policy.

While the bank revised its inflation forecasts upwards last month, Governor Kazuo Ueda has emphasized the need for caution regarding further rate hikes, citing the potential negative impact on the economy from U.S. tariffs. The Japanese economy has shown resilience despite the drag on exports caused by these tariffs.

The recent release of stronger-than-expected second-quarter gross domestic product data, combined with a U.S.-Japan trade agreement, has bolstered market confidence in avoiding a tariff-driven recession. This strengthens the argument for another rate hike later this year. Some analysts also point to pressure from Washington for further rate increases.

A recent Reuters poll revealed that a majority of economists surveyed anticipate the central bank raising base borrowing costs by the end of the year, reflecting a growing consensus on the need for further monetary tightening.