Japan's Core Inflation Dips Below 3%

The Bank of Japan remains cautious about the urgency of removing large-scale stimulus measures, which could exacerbate the widening of the US-Japan interest rate differential and put pressure on the yen. At the same time, its frequent intervention in the bond market also increases the downward pressure on the yen.

On Friday, Japan's core inflation slowed to below 3% for the first time in over a year in September, but it is still higher than the central bank's target, keeping market expectations alive that policymakers will gradually unwind ultra-loose monetary policy.

The data is one of a series of indicators that the Bank of Japan will review at a two-day policy meeting ending on October 31, when new quarterly growth and price forecasts will also be released.

Marcel Thieliant, head of Asia-Pacific at Capital Economics, said, "Although inflation eased slightly in September, we believe it will only fall below the Bank of Japan's 2% target by the end of next year."

Government data released on Friday showed that Japan's core Consumer Price Index (CPI) in September (excluding the volatile cost of fresh food) rose 2.8% year-on-year, slightly higher than the market's expected 2.7%, but down from 3.1% in August.

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The data shows that the decline in utility fees reflects the lagged effect of past oil price declines, pushing inflation to fall below 3% for the first time since August 2022. Food and daily necessities prices continue to rise, but the increase has slowed compared to August, indicating that cost pressures are easing.

The core inflation rate, which excludes fresh food and fuel costs, rose 4.2% year-on-year in September, down from the 4.3% increase in August. The Bank of Japan closely monitors this index, believing it better measures inflation trends.

Shinke Yoshiki, chief economist at Dai-ichi Life Research Institute, said that although inflation may slow down in the coming months, a resurgence in oil costs and a continued depreciation of the yen could prompt businesses to raise prices again.

Yoshiki pointed out: "There is a lot of uncertainty about the expected speed of inflation decline." He added that the core inflation rate may not fall below 2% until the second half of 2024.

The market widely speculates that the Bank of Japan will soon end negative short-term interest rates and yield curve control (YCC) to cope with the expanding inflationary pressures.The Bank of Japan (BOJ) has downplayed the possibility of gradually phasing out its massive stimulus measures in the near term, stating that it will only consider raising interest rates when recent cost-driven price increases transition into demand-driven inflationary rises.

Two sources familiar with the BOJ's thinking have indicated that merely raising inflation forecasts will not prompt the central bank to gradually withdraw its stimulus measures, as policymakers are more focused on whether wages will rise sufficiently to support consumption.

However, there are growing signs that consumers are feeling the pressure of rising prices as real wages continue to decline after adjusting for inflation.

During the quarterly meeting on Thursday, some regional branch managers of the BOJ reported that consumers have become more sensitive to price increases and have reduced their purchases at supermarkets.

A government survey targeting taxi drivers, restaurants, and other service industry companies showed that their sentiment deteriorated in September, highlighting the fragility of consumption.

Analysts have noted that although companies have proposed raises this year that have not been seen in three decades, policymakers are focused on whether this trend will continue and spread to small businesses across regions next year.

A foreign media survey suggests that core consumer inflation in Tokyo, the capital of Japan, may reach 2.5% in October, unchanged from the previous month. This data is seen as a leading indicator for national figures in Japan and will be released on October 27th.

Is the BOJ's frequent intervention in the bond market increasing downward pressure on the yen?

If inflation data supports a slower policy shift by the BOJ, it could further widen the US-Japan interest rate differential and put pressure on the yen.

In recent days, the surge in US Treasury yields has intensified the pressure on the BOJ to confront the market. As Japan's 10-year government bond yields rose to a ten-year high, the BOJ intervened in the government bond market again on Friday, marking the fifth time this month.Mitsui Sumitomo DS Asset Management's Chief Macro Strategist Masayuki Kichikawa stated, "The Bank of Japan is not trying to cap yields. It has sent a signal that the rise in yields should be gradual, not rapid. I don't know if the Bank of Japan is satisfied with this level, but the current level is still far below 1%, and there is room for it to rise."

In recent weeks, the Bank of Japan has increased its intervention in the government bond market, as the surge in U.S. Treasury yields has triggered turmoil in the global bond market. On Friday, the 10-year U.S. Treasury yield briefly broke through the psychological threshold of 5% for the first time in 16 years.

In its latest move, the Bank of Japan offered five-year collateralized loans to financial institutions, marking the second deployment of this tool this month. Its other regular option is additional bond purchases, which have been conducted three times this month, including earlier this week.

The Bank of Japan's intervention in the government bond market is akin to walking a tightrope, as it could potentially push the yen's exchange rate against the U.S. dollar to 150, a level that many consider a red line for currency intervention.

Since the Bank of Japan's July interest rate decision, the widening U.S.-Japan interest rate differential has led to a 7.1% plunge in the yen's exchange rate against the U.S. dollar, as its commitment to easing Yield Curve Control (YCC) was overshadowed by the persistent rise in U.S. Treasury yields.

However, since briefly breaking through that level earlier this month, the currency pair has stabilized near 150. Some speculate that authorities have intervened in the currency market, but official data shows that this is not the case.

The weakening yen is a political hot potato, as it has raised import prices for energy and food amid the possibility of Japanese Prime Minister Fumio Kishida considering an early election.

Kichikawa said, "If the yen's exchange rate against the U.S. dollar continues to fall below 150, the difficulty of the Bank of Japan intervening in the Japanese government bond market will certainly increase. But with the yen stable, the Bank of Japan can try to control long-term government bond yields and also observe the reaction in the foreign exchange market. This is the kind of delicate balancing act that the Bank of Japan is facing."