Japan's economy achieved stronger-than-expected growth at the start of the year, providing support for the Bank of Japan to consider further interest rate hikes, even as the economic outlook remains highly uncertain due to the impact of conflict in the Middle East. Data released by Japan's Cabinet Office on Tuesday showed that real gross domestic product (GDP) for the first quarter grew at an annualized rate of 2.1%. This figure surpassed economists' prior forecast of 1.7% and marked a clear acceleration from the downwardly revised 0.8% growth in the previous quarter. The report indicates that the Japanese economy showed signs of acceleration between January and March, before the full effects of the Middle East conflict began to materialize. Stronger-than-expected performance in private consumption and trade contributed to the faster growth. Private consumption, which accounts for over half of Japan's GDP, increased by 0.3% quarter-on-quarter (not annualized) in the first quarter, exceeding market expectations of 0.1%. This may have been supported by government utility subsidies and wage growth finally beginning to outpace inflation. However, consumer confidence has been weakening since the outbreak of the conflict. Net exports also provided more support to economic growth than anticipated. March trade data showed that Japan's export growth picked up pace as demand recovered. The pace of corporate investment growth slowed compared to the previous quarter, increasing by only 0.3%. A March survey of companies by the Ministry of Finance showed that recurring profits grew for the fifth consecutive quarter. Corporate investment appetite continues to be underpinned by the global artificial intelligence (AI) boom and rising demand for digitalization amid labor shortages. It remains unclear how the Middle East conflict, which shows no signs of ending, will continue to affect the Japanese economy. Robust economic expansion may provide policymakers with room to believe the economy is resilient enough to withstand higher borrowing costs, supporting the Bank of Japan's continued progress toward monetary policy normalization and its response to rising inflation risks. Takayuki Toji, a senior economist at Japan Post Insurance, stated, "Based on this data, the government side may be more willing to accept further rate hikes." "This could leave room for the Bank of Japan to hike rates as early as June or July, before the next GDP data is released." Despite the strong economic growth figures, the yen weakened slightly against the US dollar following the data release. Overnight swap markets showed little change, indicating that markets currently price in about a 77% probability of a Bank of Japan rate hike in June. This result comes at a particularly sensitive time for Prime Minister Sanae Takaichi, who is trying to maintain support from the public and investors. While her proposals for a supplementary budget to fund emergency relief measures and restart energy subsidies—expected to be welcomed by inflation-weary citizens—her previous vacillation on the need for additional fiscal funds may also heighten investor uncertainty regarding her fiscal plans. Takaichi and her team have not yet released specific details of the supplementary budget, including its size and financing methods.
The Door is Open for a June Rate Hike by the Bank of Japan Against the backdrop of the Middle East conflict fueling concerns about heightened inflation, the Bank of Japan is expected to continue advancing its monetary policy normalization. In a recent survey conducted between May 7 and 14, 65% of responding economists (40 out of 62) forecast that the Bank of Japan would raise rates by 25 basis points in June, bringing the policy rate to 1%, largely consistent with the results of an April survey. All but one of the 62 economists surveyed expect the central bank to hike rates by the end of September. Meanwhile, the survey median indicates that the Bank of Japan will raise the policy rate to 1.25% in the fourth quarter of this year and further to 1.50% by the third quarter of next year, also in line with last month's survey results. Furthermore, in the survey, nearly three-quarters of the economists stated that persistent inflation over the next 12 months poses a greater threat to the Japanese economy than a slowdown in demand. A senior market economist at Mizuho Securities said, "Given that the economic, price, and wage conditions supporting a rate hike currently remain in place, we believe the June meeting, about six months after the December 2025 meeting, is the most likely timing for the next hike." The Bank of Japan kept its policy rate unchanged at 0.75% last month to assess the impact of the Middle East conflict. However, three of the nine members of the Policy Board dissented and advocated for a hike to 1%, signaling policymakers' growing vigilance regarding inflation pressures stemming from energy shocks caused by the conflict. Kazuhiro Masui, a Policy Board member who voted to keep rates steady at last month's policy meeting, has publicly turned hawkish, calling for an early rate hike. Masui stated last Thursday, "I judged at the time (in April) that there was no need to rush into a rate hike, but if data shows no clear signals of an economic downturn, a hike should be implemented sooner rather than later." These remarks suggest he may join the hawkish camp and vote for a hike next month. Economists' expectations for a possible June rate hike by the Bank of Japan also echo the minutes from its April meeting. The minutes revealed that several Policy Board members argued for an early rate hike during the meeting, with one member explicitly stating the possibility of a June hike. The minutes quoted one member as saying, "Even with ongoing uncertainty about the subsequent course of the Middle East situation, it is highly likely that the Bank of Japan could start raising rates from the next meeting." Another member's opinion stated, "While there is no need to rush into action at this stage, as long as there are no clear signs of an economic slowdown, the Bank should move to raise rates as soon as possible." Another view noted that the Bank's current policy rate remains well below the economy's neutral rate level, and the Bank needs to steadily raise rates every few months; if inflation risks rise further, it should more decisively accelerate the pace of hikes. The minutes also showed that many members said the Middle East conflict is intensifying inflation pressures, increasing the risk of second-round effects and bringing forward the timing for underlying inflation to reach 2%. One member was quoted as saying, "With price expectations being significantly revised upward and uncertainty regarding the Middle East situation still high, all scenarios point to risks of further price increases." The member added, "Furthermore, if supply-side constraints materialize, they would exert extremely strong upward pressure on prices." Data released last month showed that Japan's core inflation rate, which excludes fresh food prices, accelerated for the first time in five months in March, rising to 1.8% year-on-year from 1.6% in February, influenced by concerns over energy price increases due to the Middle East conflict. Last month, the Bank of Japan also raised its forecast for core inflation, excluding fresh food, for fiscal year 2026 (April 2026 to March 2027) to 2.8% from the 1.9% projected in January this year. However, the Bank of Japan's progress in normalizing monetary policy may face constraints from the government. A government advisory panel warned that, given the deterioration in corporate financing conditions and uncertainty stemming from the Middle East situation, the Bank of Japan should maintain caution in formulating monetary policy. This statement has been interpreted externally as a direct reminder to Bank of Japan Governor Kazuo Ueda, suggesting that pushing for a rate hike in the near term, especially at the upcoming policy meeting next month, may face stronger policy headwinds. The Bank of Japan is at a crossroads in policy normalization, with internal divergence shifting from "whether to hike" to "when to hike." Reasons for caution given by dovish policymakers include geopolitical uncertainty, an unclear economic outlook, and concerns about financing conditions. But regardless of whether a hike occurs in June, a clear trend has been established—a rate hike is a matter of timing, not direction. Analysis points out that, considering combined inflation pressures, economic softness, and internal divisions, the Bank of Japan's future path presents three possible scenarios. Scenario One—Hike to 0.75% in July, with one more adjustment within the year. This scenario assumes the Middle East situation does not worsen further, with the June meeting keeping rates unchanged but sending a clear hawkish signal, followed by a rate hike in July after confirmation from inflation and wage data. This is a middle path balancing fragile domestic demand and inflation pressures. Scenario Two—An earlier hike in June, with the policy rate reaching 1.0% by year-end. If April's Producer Price Index (4.9%) and subsequent Consumer Price Index figures continue to exceed expectations, and yen depreciation pressures intensify (approaching the 160 yen per US dollar level), the central bank may opt for an earlier move in June. If calls from hawkish members gain more support, the pace of hikes would accelerate significantly. Scenario Three—Maintaining rates unchanged until the fourth quarter. If the Middle East situation escalates abruptly causing oil prices to surge, or if global economic growth slows sharply, the Bank of Japan may choose to wait until the fourth quarter. However, this probability is considered low, as persistent inflation and yen pressure are continually reducing the room for waiting.
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