Japan: New wave of cost driven inflation from protracted war in Iran raising risk of stagflation

The US-Israel war with Iran is about to trigger a new wave of cost push inflation in Japan (Chart 1). While Japan has been highly dependent on foreign energy, Brent oil prices surged to USD 87.8 per barrel from USD 72.5 just before the war erupted on February 28th. The Yen, which depreciated to USDJPY=158.2 from 155.9 during the same period (Chart 2), is expected to amplify into higher import inflation.The protracted conflict in the middle east has raised the risk of stagflation in Japan. As higher import costs are anticipated to be transferred to consumers, real wages are expected to fall once again, containing private consumption. Furthermore, a weaker Yen will probably no longer support exporters. Lower prices are unlikely to stimulate export demand, as economic uncertainties have increased globally. Hence, the positive transmission mechanism from the Yen deprecation has weakened after the war erupted.The BoJ could respond to these developments by speeding up policy normalization to stabilize the Yen and import prices. Prime Minister Takaichi is expected to endure a rate hike, as a lax monetary policy would weaken the currency and increase households’ living expenditures, which is against the government’s policy. On the other hand, the government could expand targeted reliefs such as subsidies on energies and aid to vulnerable households.These developments could also increase pressure on Governor Ueda to purchase more government bonds. As bond yields rise on the back of higher policy rate, inflation and government expenditures, fiscal position could deteriorate with increasing debt servicing costs. However, additional bond purchases should be the last resort for the BoJ. This not only goes against the BoJ’s monetary policy normalization after the termination of the yield curve control in March-24 but also could be regarded as fiscal repression.