Conflict in Iran is unsettling financial markets and oil prices, once again placing the Bank of Japan in a familiar predicament: whether to pause policy adjustments or proceed with interest rate hikes. Escalating tensions in the Middle East are driving up crude oil prices, making the central bank's policy objectives more difficult to achieve. The BOJ aims for stable 2% inflation supported by wage growth and demand, rather than cost-push factors. Soaring energy prices can elevate overall inflation, seemingly providing a rationale for raising rates. However, they also risk dampening Japanese household consumption and increasing pressure on businesses, particularly small and medium-sized enterprises already struggling with high import costs. If the BOJ holds steady to accommodate political and growth concerns, it risks further yen depreciation, which would in turn increase the cost of energy imports. Conversely, raising rates to curb inflation and support the yen could disrupt a fragile economic recovery. The current situation resembles the period following the outbreak of the Russia-Ukraine conflict, when a sharp jump in import prices forced major global central banks like the Federal Reserve and the European Central Bank to hike rates rapidly. At that time, Japan was mired in deflation and implementing the world's most accommodative monetary policy. It was therefore able to use the opportunity of rising inflation to eventually exit its long-standing quantitative easing program. However, BOJ policymakers indicate that Japan's circumstances are now different. They express a desire to avoid the trap of misreading inflation signals and adjusting interest rates too late. According to sources familiar with the policymakers' thinking, inflation expectations among Japanese companies and households are finally taking shape, with core inflation approaching the central bank's 2% target. This leaves the BOJ with little time to leisurely plan its next steps. Despite geopolitical turmoil, BOJ board members maintain a bias toward further rate hikes. However, given ongoing financial market instability and high uncertainty over the Middle East outlook, action at this week's meeting is considered highly unlikely. Markets currently assign a near-zero probability of a rate hike this week. The chance of a hike at the next meeting in April is estimated at around 60%, when the central bank will release its latest growth and price forecasts. Another complicating factor is the Japanese government's response to the Middle East crisis. The policy core of Prime Minister Sanae Takaichi focuses on economic growth and favors maintaining an easy financial environment to cushion supply shocks. Although the government is mitigating the impact on the real economy through measures like gasoline subsidies and the release of oil reserves, persistent yen weakness remains a systemic challenge. BOJ Governor Kazuo Ueda has acknowledged that as businesses become more willing to pass on cost increases to consumers, exchange rate fluctuations now have a more direct impact on domestic prices than in the past. Daiwa Securities economist Kenji Yamamoto stated, "If oil prices remain high or rise further, a vicious cycle could emerge—a worsening trade balance leading to further yen depreciation, which then pushes up import prices." Yamamoto pointed out, "Imported inflation from a weak yen continues to accumulate upside risks. In the medium to long term, this increases the likelihood of a delayed policy response, akin to allowing inflationary 'magma' to build up underground." Yamamoto expects the BOJ to wait until April to raise rates. However, considering Prime Minister Takaichi's preference for loose monetary policy, the pace of tightening may be slower than what economic fundamentals would otherwise dictate. Yamamoto added, "Whether the BOJ can smoothly execute a rate hike in April could become a turning point determining market confidence in its subsequent tightening path."
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