The prospect of a Bank of Japan (BOJ) interest rate hike in April, once considered a near certainty, has dimmed due to the ongoing Middle East conflict. The central bank's decision at its upcoming meeting this month is now highly dependent on the performance of the Japanese yen and the progress of ceasefire talks, representing a level of risk far exceeding its usual considerations.
A BOJ rate hike in April, once seen as a high-probability event, is now looking increasingly unlikely. Hopes for an end to the Middle East conflict are fading, causing sustained market turbulence and casting further uncertainty over the already fragile outlook for the Japanese economy.
The prolonged conflict has also intensified the BOJ's communication challenges. Since the start of the year, the central bank had used hawkish commentary to pave the way for a near-term rate increase. However, there is now almost no window before the next policy decision to signal a potential pause to the market.
The BOJ's policy meeting is scheduled for April 27-28, just one week after the expiration of a fragile ceasefire agreement between the US and Iran, which failed to end Iran's blockade of the Strait of Hormuz.
According to three informed sources, a divergence has emerged among BOJ policymakers: one faction is focused on intensifying inflation risks, while another prefers to wait and see how the conflict develops. Complicating the debate, Japan's Minister of Economy, Trade and Industry stated on Sunday that the persistently weak yen provides a strong rationale for a rate hike.
All signs indicate that the decision will be exceptionally difficult and highly contingent on the yen's exchange rate and the fragile two-week ceasefire situation—a level of risk far beyond what the BOJ typically faces.
"The key is how the BOJ balances upside inflation risks with downside growth risks, and the immense uncertainty from the Iran war makes this judgment extremely difficult," one source stated, a view echoed by a second source.
A third source indicated that the possibility of an April hike may have already diminished, given that the conflict could inflict greater-than-expected economic damage.
BOJ Deputy Governor Ryozo Himino said last Friday, "If the Middle East conflict persists, simultaneously dragging on growth while accelerating inflation, it would present us with a dilemma and a difficult problem." He added that the central bank would focus on the scale and duration of the shock.
The BOJ may struggle to clearly signal its policy intentions. A former executive who was responsible for BOJ monetary policy stated that during periods of high uncertainty, the standard central bank practice is to adopt a wait-and-see approach, making the outcome of this month's meeting difficult to predict.
Former BOJ official Kazuo Momma said on Monday, "The Middle East situation is currently placing the BOJ in an extremely difficult position."
"Over the next two to three months, all sorts of outcomes are possible," Momma said. "In such an uncertain environment, I believe the conventional strategy for any central bank is to wait and see how the situation unfolds."
Momma suggested that the BOJ's failure to send a clear signal regarding the near-term interest rate path indicates the bank itself may not have decided on a course of action for the April 27-28 meeting. "The April meeting will be a tough meeting," he concluded.
Pricing in overnight swap markets shows traders now assign a 44% probability to a rate hike. This figure was around 60% late last week.
Given the unpredictable nature of the conflict, the BOJ may find it difficult to provide clear hints about its rate decision—a departure from recent meetings where officials signaled intentions in advance to avoid surprising markets.
Analysts say this could lead to market volatility regardless of whether the BOJ hikes in April or not.
"If the BOJ doesn't provide additional hints, the market will start to scale back bets on April action," said Naomi Muguruma, chief bond strategist at Mitsubishi UFJ Morgan Stanley Securities. "This means that if a hike does occur, it could surprise the market and push bond yields higher."
Conversely, "holding rates steady could also push yields higher and weaken the yen due to market concerns that the BOJ is lagging in its response to inflation. So, either way, the market reaction is unlikely to be smooth."
The few remaining opportunities for the BOJ to signal its intentions include a brief speech by Governor Kazuo Ueda on Monday and a press conference he is expected to hold later this week in Washington after attending meetings for the International Monetary Fund and the Group of Twenty.
The Governor might also comment on policy if summoned to parliament, but such a date has not been set in advance.
The BOJ faces a difficult choice. With Japan's inflation rate hovering near the target level for nearly four years, the bank had been carefully laying the groundwork for a near-term hike by emphasizing growing price pressures.
Governor Ueda said in March that the BOJ would not rule out another rate hike if a war-induced economic slowdown proved temporary, leaving the possibility of an April hike on the table.
Subsequently, the BOJ released new indicators showing that underlying inflation had exceeded the target and published a report suggesting Japan is now more prone to persistent inflation than in the past.
These signals, combined with the hawkish tone of the BOJ's March meeting minutes, drove market pricing towards an April hike.
There are sound reasons for the BOJ to proceed with a hike. Unlike its US and European counterparts, its policy rate of 0.75% remains below the neutral level for the economy. With inflation around 2%, maintaining deeply negative real borrowing costs carries the risk of the economy overheating.
Delaying a hike could also lead to further unexpected yen depreciation, raising import costs and overall inflation. Japan's Minister of Economy, Trade and Industry, Ryosei Akazawa, said on Sunday that with Japanese real interest rates still quite low, an April hike "could be one option to support the yen."
Proponents of an early hike point out that rising oil prices could push up costs for a wide range of goods, and that already heightened price pressures could intensify further as companies become more aggressive in raising wages and passing on costs.
However, this hawkish momentum is facing challenges: the rapidly evolving Middle East situation, severe market volatility, and a dimming outlook for the Japanese economy, which is heavily reliant on fuel imports from the Middle East, are clouding the picture as hopes for an early end to the war fade.
Although government subsidies have curbed fuel spending, recent surveys show a sharp deterioration in business and household confidence in March. BOJ regional branch managers also warned of downside growth risks last week.
According to sources, dovish factions within the central bank worry that raising rates amid high uncertainty and market volatility could damage market confidence.
The longer the war persists, the greater the risk that supply chain shortages will disrupt economic activity.
Consequently, the BOJ is expected to lower its growth forecast and raise its inflation outlook in the quarterly report to be released at the April meeting.
"Judging from recent hawkish communication, the BOJ is likely to hike rates again in April, June, or July," said former BOJ board member Seiji Adachi. "But deciding on April will be a tough choice, as hiking when the war's economic impact is unclear would be a leap in the dark."
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