Tokyo's core inflation gauge unexpectedly slowed to its lowest pace of increase in four years, complicating the Bank of Japan's policy communication, though it may not necessarily derail market expectations for a potential rate hike as early as next month.
Data released by Japan's Ministry of Internal Affairs and Communications on Friday showed that the Tokyo Consumer Price Index (CPI) excluding fresh food rose 1.3% year-on-year in May. This marks the sixth consecutive month of deceleration for the indicator and fell below the forecasts of all but one economist surveyed.
Meanwhile, the index excluding fresh food and energy—a key measure closely watched by the Bank of Japan to gauge underlying inflation trends—increased by 1.6%. This measure is considered to provide a clearer reflection of price trends by removing distortions related to government subsidies, though it remains influenced by base effects from the unprecedented surge in prices of items like rice last year.
The overall CPI climbed 1.4% year-on-year. The Tokyo CPI is often viewed as a leading indicator for national price trends. A slowdown in the increase of processed food prices compared to last year, coupled with a significant decline in water service charges, contributed to suppressing the CPI reading. Energy prices continued to fall, benefiting from gasoline subsidies implemented under Prime Minister Sanae Takaichi. Takaichi plans to submit a supplementary budget to the Diet in the near term to sustain these subsidy measures.
The report indicates that while the government's plans have successfully alleviated living costs, they have also obscured underlying inflation trends. In addition to water charges, the Tokyo Metropolitan Government has implemented measures to reduce early childcare costs—including nursery fees, which saw a substantial drop. Some of these items have also distorted the national CPI, contributing to Japan's nationwide CPI growth in April slowing to its weakest pace in four years.
Bank of Japan policymakers remain vigilant about a potential price resurgence stemming from the conflict in the Middle East. This should afford them room to proceed with a rate hike at their next monetary policy meeting on June 15-16. According to Overnight Index Swap (OIS) data, traders as of Friday morning priced in approximately a 77% probability of a rate hike at that meeting.
Economist Taro Kimura stated, "We believe the Bank of Japan will look through the weakness in the headline data and remain alert to upside inflation risks from rising oil prices. We continue to expect the BOJ to raise rates by 25 basis points to 1% in June."
Service prices, a key indicator of demand-driven inflation, rose 1.1% year-on-year. Food prices excluding fresh food increased by 4.1%, though the pace of increase slowed from the previous month. Rice prices fell 1%, marking the first decline since August 2022 and a stark contrast to the nearly 94% surge witnessed last year.
Prime Minister Takaichi recently called for a supplementary budget to fund utility subsidies this summer and stated earlier this week that the funds would be raised without increasing regular government bond issuance. Nonetheless, concerns persist in the market about expanding fiscal spending. This, combined with a global rise in yields driven by war-induced inflation fears, has triggered a sell-off in Japanese government bonds.
The Prime Minister has also been open about her preference for accommodative policy. Last week, Takaichi told Governor Kazuo Ueda that she hopes the Bank of Japan will consider the government's price relief measures and other economic policies when formulating appropriate monetary policy. This could pose challenges as inflation risks beyond the conflict increase.
Major Japanese food manufacturers Nisshin Seifun Group and Showa Sangyo both announced on Thursday that they will raise prices on some products starting in August. These moves indicate that companies are becoming more willing to pass on higher costs to consumers, a trend that Governor Ueda has also noted.
The yen is another factor contributing to persistent price pressures by raising the cost of imported goods. As of 9:36 a.m. on Friday, the yen was trading around 159.30 per US dollar, remaining near its lowest level since Japan's Ministry of Finance intervened in the currency market on April 30. The latest intervention figures are scheduled for release later on Friday.
Two other data points released on Friday showed that industrial production in April posted its first unexpected increase since the beginning of the year, and retail sales also recovered compared to the previous month. Japan's unemployment rate fell to 2.5% last month, its lowest level since July of last year.