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

Japan experienced a spike in inflation due to increasing import costs and currency shocks, prompting a central bank official to emphasize the need for vigilance in considering such price reactions within monetary policy decisions, according to conference notes released on Monday. This warning, shared during a Bank of Japan-hosted monetary policy conference in May, underscored the central bank's concern over persistent inflation risks that could potentially lead to a gradual increase in interest rates.

The Bank of Japan (BOJ) had already raised interest rates to a 31-year high of 1% in June and is set to raise them again this week, sources have told Reuters. This action aligns with other central banks' efforts to address mounting inflation risks by either hiking or considering rate increases.

Central banks generally raise interest rates to curb demand-driven inflation. However, the COVID-19 pandemic, Russia's invasion of Ukraine, higher US tariffs, and the Middle East conflict have shifted focus towards supply-side inflation. At a panel discussion on how central banks should manage supply shocks, BOJ Executive Director Koji Nakamura questioned whether recent shocks might become more systematic and reinforced by income and wealth polarization, populism, geopolitical risk, and climate change.

Nakamura, who oversees the BOJ's division responsible for drafting monetary policy, stated that while the general approach is to overlook supply shocks, frequent ones should not be considered transient, as they can elevate underlying inflation and inflation expectations.

Nakamura highlighted that Japan had observed non-linear reactions in domestic prices to external shocks, with consumer prices surging in response to both import price and exchange rate shocks. He emphasized that such non-linearities must be factored into the conduct of monetary policy. Additionally, Nakamura pointed out a "slow-moving demographic shock" in Japan, with an aging population shrinking the labor pool and causing wages to rise, a structural factor that cannot be dismissed as temporary.

Central banks must combine quantitative data with anecdotal analysis to better understand the evolving behavior of households and firms, and how this could influence inflation expectations, he added.

Since exiting a decade-long stimulus program in 2024, the BOJ has committed to continuing rate hikes due to a tight job market, rising import costs stemming from a weak yen, and increased fuel expenses caused by the Middle East conflict, all of which heighten the risk of inflation overshooting its 2% target.