ContextSpeech by the Governor of the Bank of Japan to the Kisaragi-kai, a Tokyo business circle, on the economy, prices and monetary policy.
Why it mattersExplains why the oil shock makes inflation the bigger risk in Japan, a notable shift for a country long used to low prices.
- The Middle East tension raised oil prices and inflation pressure.
- Supply shocks raise both growth and inflation risks.
- Inflation in Japan may prove more than temporary.
- Watch closely whether underlying inflation drifts upward.
- Prioritise the risk of a large upward inflation deviation.
- Stay attentive to downside risks to growth.
Read the speech summary
1. The Middle East oil shock
Addressing a Tokyo business gathering, Bank of Japan Governor Kazuo Ueda said tension in the Middle East since late February has pushed crude oil sharply higher, drawing attention to inflation worldwide and making it more important to read current conditions correctly before setting policy; he planned to set out the bank's view on activity and prices and then its policy thinking, including responses to supply shocks like this one. The rise is smaller than in the first 1970s oil crisis but comparable with the other big surges, including the mid-2000s and the commodity spike that followed the Ukraine invasion. For an importing economy it worsens the terms of trade: Japan gets over 90% of its crude from the Middle East, and imports of mineral fuels equal about 3% of GDP, so more income flows abroad, squeezing corporate profits and household real incomes.
2. Faster pass-through and the baseline outlook
Crude is a raw material across industries, so higher prices spread: first from petroleum products to intermediate goods such as resins and fibres, within months to plastics, power charges and logistics, then in roughly twelve months to final goods and services including cars, construction, hotels and restaurants. This time passage is likely faster and wider than in 2022, because the deflationary mindset has gone, firms set wages and prices more actively, and changes to trade practices, electricity pricing formulas and a law against late payments to subcontractors have altered the environment. In the baseline scenario growth slows temporarily in fiscal 2026 but continues, supported by high corporate profits, government measures and easy financial conditions, then picks up from 2027; consumer inflation rises sharply in 2026, and underlying inflation reaches a level broadly consistent with the 2% target between late fiscal 2026 and fiscal 2027, assuming oil follows futures lower and no large supply-chain disruption occurs. Risks: prolonged turmoil would lower growth and raise inflation, severe supply-chain disruption would slow the economy sharply and skew price risks further up, while a quick ceasefire would do the opposite.
3. How resilient is the economy?
The first point to watch is whether the economy avoids serious deterioration. Corporate profits are at historic highs, a buffer for wages and investment; global AI demand supports shipments to America and Asia and output of production machinery and electronic parts, even though total exports and production are flat; releases of petroleum reserves and new supply sources for raw materials help, and Ueda calls these efforts to ease constraints crucial to avoid the severe scenario. Households have grown cautious since March, but consumption, including credit card spending, has held up, helped by stabilising food prices, wage rises and government support for energy bills. The spring wage round gave about 5% increases even at smaller firms, the third year in a row. The size of any slowdown depends on the course of the conflict, but profits, wages and supply efforts can limit downside risks.
4. Price pressure and expectations
The second point is how oil-driven pressure turns into broader prices and underlying inflation. Consumer inflation excluding fresh food has recently been below 2% but should rise; the median of the nine board members' forecasts is 2.8% for this fiscal year, with inflation above 3% for a time. Corporate prices are already moving: producer prices rose 4.9% in April, the fastest in nearly three years, upstream in petroleum, coal and chemicals and now midstream in plastics. Expectations are rising: the Tankan shows firms lifting price forecasts, their inflation outlook has risen, and market-based long-term expectations from inflation-linked bonds are above 2%. Weak activity could push underlying inflation down, but the data so far suggest upside price risks are larger and will appear sooner, so the bank watches whether actual prices lift expectations and push underlying inflation above 2%.
5. Monetary policy and supply shocks
Since ending large-scale easing in March 2024 the bank has raised its rate to 0.75%, but real interest rates remain negative, especially at short and medium maturities. Funding costs remain low relative to profitability, bank lending and corporate bond issuance have grown strongly, lenders' attitudes remain accommodative, and most bankruptcies stem from rising prices and labour shortages rather than interest burdens; firms cite labour shortages and material costs as the main brake on investment, so accommodative conditions have supported activity. On supply shocks, the basic principle is that policy should not respond to temporary inflation from such a shock, but if it spreads to many items and raises expectations, a response is needed, as Europe and the US learned in 2022-23. Spillovers are likelier when shocks are large and persistent, when firms' price-setting is active and when financial conditions are easy, and all three apply now: the shock is comparable with past big ones, wages and prices rise in interaction again, and real rates are low, unlike the neutral policy rates in the US and Europe. When growth risks and price risks both rise, there is no single answer, but the bank should be more vigilant about a significant upward inflation deviation, since a delay could force a large later hike that burdens the economy and markets, and a perception of inaction can lift long-term yields, which already reflect higher inflation expectations.
6. Future policy, bond purchases and conclusion
If the baseline looks more likely, the bank will keep raising its rate at an appropriate pace; even if the situation is unclear, should price risks outweigh growth risks it must discuss thoroughly the pros and cons of a hike. On government bond purchases, monthly buying is being cut by about 200 billion yen each quarter through March 2027 to 2.1 trillion yen, a third of the pre-reduction level, with holdings down about 16-17%, and flexibility to step in if yields jump. An interim assessment is due at the June meeting. Market functioning has improved: cash bond volumes are rising and the dip in 7-10 year yields has largely vanished. But investors are still absorbing more bonds, which takes time, and market participants, met in late May with minutes released, showed few calls to change the plan to March 2027 but various views on purchases from April 2027, and Ueda said further reductions will be taken up at the next meeting, weighing market functioning against the stability of the bond market. He also reminded the audience that the government is securing alternative supplies and easing household energy costs, and that the bank's job is price stability, which protects both activity and financial markets. Ueda concluded that Japan, long deflationary, faces a supply shock in an inflationary period for the first time in decades, so the remedies differ; with the government's supply and household support, the bank's policy, firms and lenders, Japan can withstand the shock.
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