BOJ on hold in July, but case for another rate hike is taking shape

THE Bank of Japan (BOJ) left its policy rate unchanged at 1 per cent at its July monetary policy meeting, a decision that came as little surprise.

Following June’s historic rate hike, which lifted borrowing costs to their highest level in more than three decades, policymakers were widely expected to pause and assess how the economy responds before taking their next step.

The July vote may have appeared dovish; only one board member backed an immediate rate hike. However, the case for another 25-basis-point rate hike before the end of 2026 is steadily falling into place.

Headline inflation tells half the story

Most investors naturally focus on consumer inflation when assessing whether a central bank is likely to tighten policy. By that measure, Japan appears relatively benign.

Headline consumer inflation rose 1.7 per cent year on year (yoy) in June, while core inflation edged up to 1.6 per cent. Both remain below the BOJ’s 2 per cent target.

At first glance, Japan’s inflation appears well contained, especially compared with the US and Europe, where core inflation has remained above 2 per cent and headline inflation has hovered around 3 per cent in recent months.

But this comparison is somewhat misleading. Japan continues to cushion households with extensive government subsidies, including a petrol price ceiling and support for electricity and natural gas bills. These measures have helped offset the sharp rise in energy prices triggered by ongoing geopolitical tensions in the Middle East, effectively suppressing headline inflation.

The underlying inflation picture becomes much clearer once we turn our attention to producer prices. Producer inflation has climbed steadily from 2.9 per cent in March to 5.4 per cent in April, 6.6 per cent in May and 7.1 per cent in June, marking four consecutive months of stronger price growth.

The latest increase was driven primarily by two groups of products – energy-related goods and semiconductor-linked industries.

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Petroleum and coal product prices surged 22.8 per cent yoy, while higher crude oil and naphtha prices lifted chemical product prices by 14.4 per cent, highlighting the widespread pass-through of elevated energy costs across Japan’s manufacturing sector.

As geopolitical tensions in the Middle East continue to flare up and crude oil prices climb back above US$100 per barrel, manufacturers are likely to face sustained cost pressures in the months ahead.

At the same time, the artificial intelligence investment boom continues to support strong pricing power across Japan’s semiconductor supply chain. Prices of information and communications equipment increased 14.5 per cent, while non-ferrous metals, critical inputs for semiconductor manufacturing, power grids and AI infrastructure, surged 39.2 per cent.

Despite recent volatility in global semiconductor equities, underlying AI demand remains exceptionally resilient. From record capital expenditure by major US hyperscalers to persistent memory supply constraints, the industry’s fundamentals continue to point towards sustained investment rather than a slowdown.

As these higher production costs gradually work their way through supply chains, they are likely to exert further upward pressure on consumer prices over the coming months.

Weaker yen adds fuel to the fire

Inflationary pressure is being amplified by a rapidly weakening yen. The Japanese yen traded in a narrow range of 161 to164 yen against the US dollar throughout most of July, before strengthening following an intervention by authorities on Jul 31.

The US Federal Reserve maintained a hawkish stance at its July meeting, with three policymakers voting in favour of another rate hike. The prospect of an even wider interest rate differential continues to encourage capital outflows and weigh on the yen.

The impact is already visible in Japan’s import prices. In June, import prices increased 29.7 per cent yoy in yen terms, compared with 17.8 per cent when measured in contract currencies. The gap of roughly 12 percentage points reflects the direct inflationary impact of currency depreciation, as a weaker yen makes imported food, fuel and industrial materials significantly more expensive.

There is also reason to believe the currency effect will intensify. June’s producer price index (PPI) was calculated using an average exchange rate of 160.80 yen per US dollar. While the yen briefly rebounded following the intervention on Jul 31, history suggests such interventions tend to have only a temporary impact.

Moreover, the BOJ’s relatively dovish tone and the fact that only one board member voted in favour of another rate hike could keep downward pressure on the yen. Should the currency weaken again, producer inflation could accelerate further in the coming months as higher import costs continue to filter through the economy.

Room to tighten

Unlike previous inflation episodes, today’s inflation is being reinforced by rising wages rather than simply imported costs.

Japan’s largest labour union, Rengo, reported that companies agreed to average wage increases of 5.01 per cent, marking the third consecutive year that pay rises have exceeded the 5 per cent threshold.

Meanwhile, the government’s advisory panel recommended increasing the national average minimum wage by 55 yen (US$0.35), or 4.9 per cent, to 1,176 yen per hour for fiscal 2026.

Combined with government subsidies that have eased the burden of higher living costs, stronger wage growth has helped push real wages back into positive territory this year. This provides households with greater purchasing power and supports domestic consumption despite an uncertain external environment.

Recent economic data reinforces this picture. Retail sales accelerated to 5.3 per cent yoy in May, up sharply from 2.8 per cent in April, reflecting stronger consumer spending. External demand has also remained robust, with exports rising 19.3 per cent, marking a fourth consecutive month of double-digit growth.

The weaker yen has undoubtedly supported exporters, but shipments have also benefited from resilient global demand for AI-related semiconductors and data centre equipment.

Taken together, these developments suggest that Japan’s economy is becoming increasingly capable of absorbing higher interest rates. As inflation broadens, wage growth strengthens and domestic demand remains resilient, the BOJ has growing confidence in its path of gradual policy normalisation.

Favourable investment case

For investors, Japan’s gradual shift away from ultra-loose monetary policy remains a constructive development rather than a headwind.

Higher interest rates should continue to improve profitability for banks and insurers through wider lending margins, while companies with strong pricing power are well positioned to benefit from a healthier inflation environment.

Combined with ongoing corporate governance reforms, resilient earnings growth and structural investment in AI, the outlook for Japanese equities remains favourable.

The writer is a senior research analyst with the research and portfolio management team at FSM Global, the B2C division of iFast Financial, which is the Singapore subsidiary of iFast Corporation