Rising costs of oil and commodities are feeding through to consumer goods, pushing Japan's inflation higher in July and complicating the policy path for the central bank as it weighs the risks of a rate hike next month.

The core-core inflation index, which strips out volatile fresh food and energy prices, rose 1.9% year-on-year in July, marking the first pickup in nine months. This key price gauge is closely watched by policymakers.

Friday's data also showed that the core inflation measure, which excludes only fresh food, climbed 1.8% in July, up from 1.6% in June. Headline inflation ticked up to 1.9% in July from 1.6% the previous month, driven by naphtha-fueled price increases on everyday items. The figures underscore Japan's vulnerability to high energy and petrochemical costs amid ongoing Middle East conflicts.

Naphtha, a petroleum derivative used in plastics and manufacturing, has seen tight supply and rising prices, lifting the costs of detergents, plastic bags, and other household essentials. Economists noted that Friday's inflation readings were broadly in line with market expectations, intensifying speculation that the Bank of Japan could raise its policy rate by around 0.25 percentage points to 1.25% at its September meeting. The central bank aims to keep inflation at around 2%, and some economists have criticized it for lagging behind the curve as price pressures build.

Krishna Bhimavarapu, Asia-Pacific economist at State Street Global Advisors, expects a hike in September, stating that the BoJ's policy normalization has made substantial progress. He added that economic momentum continues to improve, and the cost pass-through from naphtha inflation is evidence of evolving inflation and price expectations, noting that the economic environment in Japan is now vastly different.

Market pricing suggests a 70% probability of a rate increase in September. Many speculators believe the central bank is under pressure to raise rates in tandem with government efforts to intervene in the currency market. In July, after the yen fell to nearly a four-decade low against the dollar, Japanese authorities coordinated with the U.S. on intervention totaling around $85 billion. The yen surged sharply at the time but has since drifted back to near 159 per dollar. Tokyo traders said expectations of a possible BoJ hike in September and another in December are providing some support for the currency.

One trader remarked that the central bank faces pressure to act early, as failing to meet market expectations could draw criticism if the exchange rate suddenly drops. The BoJ raised rates to 1% in June, a landmark step in its broader push to exit decades of ultra-loose monetary policy and normalize policy.

Before June, many market economists had assumed the central bank would stick to its roughly every-six-month, 25-basis-point pace of hikes, which would place the next move at the October or December meetings. However, a more hawkish tone from the BoJ has shifted expectations for the timing of the next hike. At its July meeting, the policy board voted to hold rates steady but signaled in its accompanying outlook report that core consumer price index inflation could accelerate to clearly above 2% in the fiscal year ending March 2027.

Market attention now turns to upcoming data and central bank communications for further clues on the timing and scale of any move.