Middle East tensions could severely hurt the economy in Japan

Our scenario analysis reveals a partial shutdown of the Strait of Hormuz by Iran would push the Japanese economy into a near-stagflation situation in H2 2025, given Japan’s structural vulnerability to terms of trade shocks.

Under this scenario, Japan’s real GDP would be 0.6% below our current baseline in 2026, which is already dampened by US tariff developments. Both consumers and businesses would suffer from higher energy costs. Despite weaker growth prospects, inflation will stay higher due to elevated energy costs and supply chain disruptions.

The vulnerability is due to Japan’s energy mix. With limited contribution from renewable energy and nuclear power, Japan relies heavily on LNG and crude oil as energy sources, both of which are sensitive to geopolitical risks in the Middle East.

We think the government will play a central role in mitigating impacts on the economy by providing a support to damaged households and businesses. Depending on the oil price and financial market developments, the Bank of Japan might opt to cut its policy rate for the first time since 2016, pausing its monetary normalization process.