Japan's core inflation slows to 2-year low, complicates BOJ rate-hike timing

A separate index seen as a better indicator of underlying inflation also slowed but remained well above the Bank of Japan's target, suggesting that solid wage gains will keep the central bank on course to push up still-low borrowing costs.

The data adds to recent mixed signs in the economy which barely grew in the final quarter of last year, but saw exports jump and manufacturers' confidence improve so far this year.

"With price pressures showing signs of softening, the Bank of Japan won't be in a rush to resume its hiking cycle. However, we still believe conditions will be in place for the Bank to raise rates by the middle of the year," said Abhijit Surya, senior APAC economist at Capital Economics.

The year-on-year increase in the core consumer price index (CPI), which excludes volatile fresh food costs, matched a median market forecast and slowed from a 2.4% gain in December.

The drop was largely due to the effect of fuel subsidies, an abolition of gasoline tax surcharges and the base effect of last year's spike in food prices, the data showed.

The BOJ has said such one-off factors will likely push core inflation briefly below its target, but has stressed it was focusing more on whether Japan will achieve wage-driven, durable price rises of around 2% in timing further rate hikes.

An index stripping away both fresh food and fuel prices, which is closely watched by the BOJ as a better indicator of demand-driven inflation, stayed well above its target to rise 2.6% year-on-year in January.

But it was lower than a 2.9% gain in December and matched a low hit in February 2025, as food price increases ran their course.

Services inflation was steady at 1.4% with price rises of private services slowing to 1.9% from 2%, the data showed, suggesting firms were slow in passing on rising labour costs.

Taken together, headline inflation slowed to 1.5% in January from 2.1% in December, falling below the BOJ's 2% target for the first time in nearly four years and heightening communication challenges for the central bank's rate-hike plan.

Conflicting drivers

The yen briefly fell after the data, then bounced back to stand at 155.10 per dollar on Friday.

The central bank ended a decade-long, massive stimulus in 2024 and raised rates in several steps including in December, on the view Japan was making steady progress in durably achieving its 2% inflation target.

Analysts expect core inflation to stay below 2% in coming months due to the effect of government fuel subsidies, which may offset upward pressure from rising import costs due to a weak yen.

Such conflicting drivers of inflation may sway the timing of the BOJ's next rate hike. A majority of economists polled by Reuters expect the central bank to raise its key interest rate to 1% from the current 0.75% by end-June. Markets have priced in roughly a 70% chance of a hike by April.

While making no explicit demands to sustain low rates, dovish Prime Minister Sanae Takaichi on Wednesday voiced hope for the BOJ to cooperate with government efforts to achieve durable 2% inflation accompanied by wage gains.

The head of Japan's banking lobby said on Thursday he saw a "reasonable possibility" of a rate hike as early as March or April in a rare, direct remark on the BOJ's possible move.

The BOJ may cut its inflation forecasts in April as weak-yen pressure has eased since it made its current projections in January, said Toru Suehiro, chief economist at Daiwa Securities.

"The hurdle for additional rate hikes is high. I see the chance of a rate hike in March or April as low," he said.