Higher oil prices add to the case for faster rate hikes in Japan

The Bank of Japan raised its policy rate to 1.25%from 1% today. We expect the BoJ will hike again in December and April 2027 to a terminal rate of 1.75%, which is our estimate for the neutral rate. However, the recent oil price rises have raised the possibility of a higher terminal rate.

The BoJ cited rising risks of underlying inflation overshooting the target of 2%, driven by the Middle East conflict, the AI boom, and yen weakness, to justify the hike. The BoJ is increasingly emphasizing these upside risks and appears more open to raising rates at a faster pace than before given the changing inflation dynamics. Pressure from the US appears to have lowered the political hurdle to rate hikes.

While the BoJ is unlikely to hesitate to raise the policy rate again in December or January 2027 to fend off pressure from the weaker yen, another hike to 1.75% will be a more delicate decision given that the policy rate is approaching the neutral rate. The government will also be keen to slow down rate normalization.

If the recent rise in oil prices persists, the risk that Japan’s economy will slide into mild stagflation will rise. If the Brent oil price stays at around $100/bbl in the coming quarters, the CPI inflation rate will rise by nearly 0.5ppts and growth will slow to 0% in 2027. In that case, the BoJ may need to hike the policy rate further to 2% by July 2027 to contain inflation expectations, especially if the yen weakens further.