Soaring oil prices combined with a weak yen are heightening the risk of Japan sliding into stagflation. This situation is likely to force the government to increase fiscal spending while complicating the central bank's mission to normalize monetary policy.

As hostilities in the Middle East escalated and pressures on oil transportation and global energy infrastructure widened, oil prices exceeded $110 per barrel on Monday. The yen weakened against the US dollar, approaching the critical level of 160—a threshold that prompted authorities to intervene and support the currency in 2024. Japanese stock markets also experienced significant declines, with the Nikkei 225 index falling by approximately 7% during Monday's morning session, while long-term government bond yields rose.

Substantial oil price increases have dampened optimism regarding the nation's economic outlook and corporate earnings, driving market panic in Japanese equities to its highest level since the 2020 COVID-19 crisis. On Monday, the one-year implied volatility for the Nikkei 225 index surged above 30 points, marking the highest reading since March 2020, when the pandemic spread globally and financial markets stalled worldwide. Another closely watched indicator, the Nikkei Volatility Index, also jumped to 66 points, its highest level since August 2024.

Japan, which relies on imports for the majority of its energy needs, finds its economy and inflation data highly susceptible to fluctuations in crude oil prices. In the current predicament, the combination of soaring oil costs and a feeble yen is jointly intensifying price pressures.

The surge in oil prices coincides with economic data scheduled for release on Tuesday, which is expected to confirm that private consumption showed almost no growth in the fourth quarter. Households remained cautious about discretionary spending amid an already high inflation environment.

Concerns over Japan's cost-of-living crisis continue to build. Last month, Prime Minister Sanae Takaichi led her party to a decisive election victory, partly due to public expectations that her expansionary fiscal policies would support households after four consecutive years of inflation above the Bank of Japan's target. Should inflationary pressures appear set to worsen, she may consider adopting an even more fiscally expansive strategy.

"This is a double blow for Japan," said Yuichi Kodama, chief economist at the Meiji Yasuda Research Institute. "The combination of soaring oil prices and a weak yen will significantly drag on the Japanese economy. There is no doubt that stagflation risks are rising."

Kodama emphasized that the impact hinges entirely on how long oil prices remain elevated. He stated that if the price surge persists, Prime Minister Takaichi would certainly need to consider introducing a new economic stimulus package. Further increases in spending could reignite investor concerns about the nation's long-term fiscal health—worries that previously triggered a significant sell-off in Japanese government bonds in January.

According to data from Japan's Ministry of Trade, the nation's reliance on Middle Eastern oil has hovered around 90%, reaching 95.1% in January. The majority of this oil is shipped to Japan via the Strait of Hormuz.

Brent crude rose more than 20% on Monday to around $112 per barrel, extending last week's 28% gain. The yen weakened to approximately 158.71 per US dollar as safe-haven sentiment bolstered demand for the US currency.

Kodama anticipates that the current economic and market conditions will lead the Bank of Japan to pause on interest rate hikes temporarily, as officials need to assess the potential severe impacts of the conflict involving Iran.

"The Bank of Japan is in a very difficult position," Kodama said. "They want to raise interest rates under favorable economic conditions, but the situation in the Middle East could seriously hamper the economy."

Data expected on Tuesday is projected to show that the Japanese economy grew at an annualized rate of 1% in the final quarter of 2025, following a contraction of 2.6% in the previous quarter.