Soaring oil prices combined with a depreciating yen are increasing the risk of stagflation in Japan, prompting the government to consider additional fiscal spending and complicating the Bank of Japan's path toward policy normalization. On Monday, oil futures surged past $100 per barrel as escalating conflict in the Middle East intensified pressure on global energy infrastructure and transportation routes. The yen weakened against the U.S. dollar, approaching the key level of 160 yen per dollar, a threshold that previously triggered government intervention in 2024 to support the currency. Japanese equities also experienced significant declines, with the Nikkei 225 index falling approximately 6.9% in early Monday trading, while long-term government bond yields moved higher.

Japan, which relies heavily on imported energy, is particularly vulnerable to fluctuations in crude oil prices, making its economic and inflation data highly sensitive to such shifts. The current combination of rising oil costs and a weak yen is amplifying overall price pressures. This surge in oil prices coincides with data expected on Tuesday, which is forecast to show that private consumption saw minimal growth in the fourth quarter, as households remained cautious about discretionary spending amid persistent inflation. Concerns about rising living costs in Japan continue to mount.

Last month, Prime Minister Takaichi Sanae led her party to a decisive election victory, partly due to public expectations that her expansionary fiscal policies would bolster household finances, following four consecutive years of inflation exceeding the central bank's target. Should inflationary pressures intensify further, she may be compelled to implement more aggressive fiscal stimulus measures. According to Yuichi Kodama, Chief Economist at Meiji Yasuda Research Institute, "This is a double blow for Japan. Soaring oil prices coupled with yen weakness will deal a heavy blow to the economy. The risk of stagflation is undoubtedly rising." Kodama emphasized that the duration of elevated oil prices will be critical, noting that if the trend persists, Prime Minister Takaichi would likely need to consider a new economic stimulus package.

However, additional government spending could reignite investor concerns over Japan's long-term fiscal health, worries that previously triggered a bond market sell-off in January. Data from Japan's Ministry of Economy, Trade and Industry indicates the country's reliance on Middle Eastern oil has remained around 90%, reaching 95.1% in January. Most of these imports transit through the Strait of Hormuz. On Monday, spot Brent crude prices jumped by as much as 20%, reaching around $111 per barrel, extending a 28% surge from the previous week. Meanwhile, the yen weakened to approximately 158.71 against the dollar as risk-off sentiment bolstered demand for the U.S. currency.

Kodama anticipates the current economic and market conditions will lead the Bank of Japan to delay any increase in its benchmark interest rate, as policymakers assess the potential severe impacts of the conflict in the Middle East. "The Bank of Japan is in a very difficult position," Kodama stated. "They want to raise rates under favorable economic conditions, but the situation in the Middle East could impose a significant drag on the economy." Data scheduled for release on Tuesday is expected to show that Japan's economy grew 1% quarter-on-quarter in the final three months of 2025, rebounding from a 2.6% contraction in the previous quarter.