Japan's consumer price growth slowed further in February, falling below expectations. However, the Bank of Japan is likely to overlook this near-term moderation in inflation and maintain its focus on upside price risks.

Positive outcomes from annual wage negotiations and stronger-than-expected Purchasing Managers' Index (PMI) data have increased the likelihood of an interest rate hike in April. Nevertheless, the final timing remains contingent on developments in the Middle East situation.

Government utility subsidies were a significant factor behind the noticeable decline in February's inflation. Japan's Consumer Price Index (CPI) rose 1.3% year-on-year in February, down from 1.5% in January and below market consensus, indicating a larger-than-expected slowdown. A 4.5% drop in fresh food prices and a 5.5% decrease in utility costs were the primary contributors to the overall inflation retreat. On a seasonally adjusted basis, the CPI fell 0.2% month-on-month. Goods prices declined 0.6% sequentially, while services prices saw a modest increase of 0.1%.

Despite the actual inflation data falling short of forecasts, the Bank of Japan is unlikely to place excessive weight on this short-term softening, as it is largely driven by government utility subsidies. The central bank will pay closer attention to the underlying inflation trend after excluding food and energy prices. The "core-core" inflation rate, which strips out both food and energy, edged down to 2.5% in February from 2.6% previously, matching market expectations, but remains significantly above the Bank of Japan's 2% target.

Headline inflation is expected to stay below 2% in the coming months, while core inflation remains sticky. Despite a significant rise in gasoline prices, the headline CPI year-on-year increase is projected to remain under 2% in the upcoming months, influenced by the government's fuel price cap policy. Base effects will also continue to suppress inflation readings. However, core-core inflation is forecast to persist at a sticky level around 2.5%.

Given the positive initial results from this spring's wage negotiations, inflationary pressures from the demand side are expected to remain intact.

Preliminary wage negotiation results are encouraging. Rengo, Japan's largest trade union confederation, announced that the average wage increase this year is 5.26%, slightly below the preliminary figure of 5.46% from the same period last year. This figure will be revised multiple times subsequently. It is noteworthy that the impact of the Middle East situation on wage talks has been very limited so far.

Bank of Japan Governor Kazuo Ueda has previously emphasized that policymakers are closely monitoring whether wage increases will sufficiently cover small and medium-sized enterprises. Many of these smaller firms will finalize wage agreements in April, making this a key focus for markets. The final results are expected to be announced before the Bank of Japan's April meeting.

Although preliminary PMI figures declined, they remain in expansion territory. The preliminary Japan Manufacturing PMI for March fell to 51.4 from 53.0 in February, with both output and new orders declining. The preliminary Services PMI also decreased to 52.8 from 53.8 in February.

This moderation is largely attributed to the recent global oil supply shock and a reduction in new orders, raising some concerns about the economic outlook. However, both PMI indices remain above the 50-point threshold, indicating expansion and suggesting that businesses generally view current geopolitical risks as temporary, with overall business confidence still leaning positive.

The Bank of Japan is set to proceed with interest rate hikes, disregarding short-term inflation fluctuations. The exact timing remains uncertain, anticipated between April and June, though the probability of an April hike is now considered slightly higher than one in June.

Sticky core inflation, stronger-than-expected PMI data, and the positive start to the spring wage negotiations have collectively increased the odds of an April rate increase.

Developments in the Middle East are seen as a critical variable in the decision-making process. If the situation stabilizes promptly without signs of significant declines in production or consumption, the likelihood of an April hike would increase further.

Overall, despite the unexpected dip in February's CPI, the Bank of Japan's focus remains on the underlying inflation trend, the sustainability of wage growth, and economic resilience. Barring a further deterioration in the Middle East situation that significantly hampers Japan's economic activity, the probability of a Bank of Japan rate hike in April remains relatively high. Markets should continue to monitor the final wage negotiation outcomes and geopolitical developments closely.