Japan's Inflation Slows, But Rate Hike Still on the Table

In Tokyo's Koto Ward, food products are displayed at a supermarket. Japan's core inflation, excluding fresh food, saw a second consecutive month of slowing in July. However, it remained above the Bank of Japan's 2% target. This has kept alive the possibility of another interest rate increase in the coming months.

Government data released on Friday revealed that the nationwide core consumer price index (CPI) increased by 3.1% in July compared to the previous year. This was slightly higher than the market's median forecast of a 3.0% gain. The increase was less than the 3.3% rise seen in June, primarily due to the base effect of last year's energy price increases, which stemmed from the end of government subsidies aimed at curbing fuel costs.

Economists suggest that inflation is clearly decelerating from its peak of 3.7% in May. They anticipate this easing trend to continue throughout the year, driven by a moderation in rice price surges and the reinstatement of energy subsidies. Despite this, inflation remains elevated, supporting the argument for the Bank of Japan (BOJ) to raise interest rates, potentially as early as October.

Energy prices experienced a 0.3% decrease, marking the first year-on-year drop since March of the previous year. Conversely, food inflation, excluding volatile fresh products, accelerated to 8.3% in July from 8.2% in June. This indicates that rising living costs continue to burden households. A separate index, which excludes both fresh food and fuel costs, rose 3.4% in July, the same rate as in June. This index is closely monitored by the BOJ as a measure of domestic demand-driven prices.

Elevated food and raw material costs have kept Japan's core inflation above the BOJ's 2% target for over three years. This has raised concerns among some policymakers about potential second-round price effects. The BOJ ended a decade-long period of significant stimulus last year and increased short-term interest rates to 0.5% in January, believing that Japan was close to sustainably achieving its 2% inflation target.

While the bank adjusted its inflation forecasts upwards last month, Governor Kazuo Ueda has emphasized the need for caution regarding further rate hikes. This is due to the anticipated impact on the economy from U.S. tariffs. The Japanese economy has shown resilience despite the negative effects of these tariffs on exports.

Strong second-quarter gross domestic product data, released last week, coupled with a U.S.-Japan trade agreement reached last month, has fueled market expectations that a tariff-driven recession will be avoided. This strengthens the case for another rate hike later this year. Some analysts also point to pressure from Washington for more rate hikes.

A recent Reuters poll revealed that 63% of economists surveyed this month expect the central bank to raise base borrowing costs to at least 0.75% from 0.50% by the end of this year. This is an increase from 54% in the previous month's poll.