BOJ executive saw need for vigilance to ’non-linear’ inflation spikes

Japan experienced an inflation spike due to rising import costs and currency shocks, prompting a central bank official to emphasize the importance of factoring such price reactions into monetary policy considerations, according to conference notes released on Monday. At a Bank of Japan-hosted conference on monetary policy in May, the official highlighted the central bank's alarm over persistent inflation risks that could potentially lead to gradual interest rate hikes.

The BOJ had already raised interest rates to a 31-year high of 1% in June and is set to increase rates once again this week, according to sources familiar with the matter. Central banks generally raise interest rates to curb demand-driven inflation. However, the COVID-19 pandemic, Russia's invasion of Ukraine, higher U.S. tariffs, and the Middle East conflict have all drawn attention to supply-side inflation.

During a panel discussion on how central banks should handle supply shocks, BOJ Executive Director Koji Nakamura questioned whether recent shocks might be more systematic and driven by income and wealth polarization, populism, geopolitical risk, and climate change. Nakamura, who oversees the BOJ's division responsible for monetary policy drafting, stated that persistent shocks should not be viewed as temporary because they can escalate underlying inflation and expectations.

Japan had indeed observed non-linear reactions of domestic prices to external shocks, with consumer prices experiencing sharp increases in response to both import price and exchange rate shocks, Nakamura asserted. These non-linearities must be considered when implementing monetary policy. In addition to supply-side factors, Japan faces a slow-moving demographic shock due to an aging population and shrinking labor pool, which is lifting wages and poses a structural challenge that cannot be dismissed as temporary, Nakamura added.

Central banks must combine quantitative data with qualitative analysis to better understand evolving household and firm behavior and its potential impact on inflation expectations, he concluded. Following the exit from its decade-long stimulus program in 2024, the BOJ has committed to maintaining rate hikes in the face of a tight job market, rising import costs from a weakening yen, and higher fuel costs stemming from the Middle East conflict, all of which heighten the risk of inflation surpassing its 2% target.