Iran Conflict Fuels Inflation Risks, Bolstering Case for Japan Rate Hike

Introduction

In an increasingly complex global landscape, geopolitical developments can have far-reaching economic implications. Notably, the ongoing conflict involving Iran is being identified as a potential catalyst for upward inflationary pressures, particularly for import-reliant economies. Toshitaka Sekine, a distinguished former chief economist at the Bank of Japan (BOJ), has voiced concerns that these heightened risks could provide the central bank with compelling justification to raise interest rates sooner rather than later, potentially as early as its upcoming policy meeting.

Expert Analysis on Timing

Mr. Sekine stated in a recent interview that an April policy move would be "perfectly reasonable" for assessing the situation. He believes that by the end of April, the residual effects of the Middle East tensions will become clearer, indicating whether they are likely to be a short-term phenomenon. While academic debate continues regarding the precise inflationary or deflationary impact of such geopolitical shocks on resource-scarce nations like Japan, Sekine's remarks suggest a growing conviction among policymakers about the necessity of a rate hike when the BOJ's policy board convenes on April 28th.

Evidence Supporting a Policy Shift

Drawing upon his extensive career of over three decades at the BOJ, ending in 2020, Sekine surmises that many of his former colleagues likely share his perspective. This view is reinforced by the concise minutes of the March policy meeting, which explicitly documented a rising concern among committee members regarding inflation risks. He points out that Japanese households have already endured inflation exceeding the BOJ's 2% target for four consecutive years. Against this backdrop, the Iran conflict could trigger a "supply shock" that pushes inflation higher. A previous estimate by the Cabinet Office indicated that a 10% increase in oil prices could lift the inflation rate by up to 0.3 percentage points. Given that oil prices have surged by approximately 50% since the conflict began, the inflationary impact is becoming increasingly tangible.

Past Experiences and Market Expectations

Sekine emphasizes a key distinction from his tenure at the BOJ: Japan has experienced a "real inflation overshoot" since 2022. Considering this, he personally leans towards favoring a rate hike if another supply shock threatens to push prices out of control once more. This sentiment aligns with trader expectations, who currently assign a roughly 70% probability to a rate hike by the BOJ's policy board this month. However, many BOJ observers note that the ultimate decision will hinge on the unfolding events in the Middle East, particularly as BOJ Governor Kazuo Ueda has committed to closely monitoring both upside and downside inflation risks.

Upside Risks and Fiscal Pressures

Sekine asserts that the "upside risks are much larger." He further notes that Finance Minister Sanae Takaichi has been increasing fiscal spending to manage living costs, with a strong likelihood of further follow-up measures. He posits that this fiscal action could, in turn, create inflationary pressures from the government's side. While Takaichi has signaled a preference for a more gradual pace of rate adjustments, the critical question remains whether the minister will attempt to curb rising borrowing costs as the economic outlook grows more uncertain.

Consequences of Inaction

However, Sekine issues a stern warning about the potentially dire consequences if the BOJ fails to fulfill its mandate of price stability due to political considerations. He describes a probable scenario where "foreign investors might go on a selling spree of the yen," leading to its further depreciation. Coupled with rising oil prices, this could propel upside inflation pressures to "extremely uncomfortable levels."

Confidence in Leadership

Sekine, now an economics professor at Hitotsubashi University, expresses strong confidence in Governor Ueda, characterizing him as an "academic" leader. He believes Ueda will take all actions he deems necessary, especially given Ueda's successful track record of scaling back the bank's massive monetary easing policy, even in the face of widespread market skepticism. Sekine views this as a "severe test moment" for Governor Ueda, albeit one he may not welcome. He concludes by stating that historical experience demonstrates that "inaction" by central banks can lead to catastrophic outcomes, a fact that Governor Ueda is undoubtedly aware of.