Inflation cooling does not change the determination to raise interest rates? Japan's core CPI in January fell to a two-year low, increasing pressure on the central bank to communicate.

A key inflation indicator in Japan has fallen to its lowest level in two years, posing a communication challenge for the Bank of Japan - despite cooling data, the central bank is likely to continue to raise interest rates when the time is right. Following the data release, the yen weakened in response. On Friday, Japan's Ministry of Internal Affairs and Communications announced that the core CPI excluding fresh food rose 2.0% year-on-year in January, the smallest increase since January 2024, in line with economists' median expectations, with the previous value up 2.4%. At the same time, the index, which excludes food and energy and better reflects underlying inflation pressures, rose by 2.6% year-on-year, still well above the Bank of Japan's 2% inflation target. The overall inflation rate, including all items, fell to 1.5%, dropping below the 2% level for the first time since March 2022. Friday's data showed that the rate of increase in Japanese prices has slowed compared to last year, partly due to fiscal measures introduced by Japanese Prime Minister Kanon - aimed at easing the pressure of living costs. In 2025, Japan's inflation rate excluding fresh food temporarily soared to 3.1%, remaining above 2% for the fourth consecutive year. The slowdown in inflation this time is mainly due to temporary factors and food price drivers. In January, the government reduced fuel costs through measures such as tax cuts, leading to a 5.2% year-on-year drop in overall energy prices; at the same time, food prices excluding fresh food also narrowed due to the high base effect of the same period last year. Taro Saito, director of the NLI Research Institute, stated: "The weakness in food inflation and the decline in gasoline prices are the two main reasons for the slowdown in inflation this time. With the effect of government utility subsidies becoming apparent, core CPI is almost certain to drop below 2% in the next round of data." Following the data release, the yen fell against the US dollar, briefly dropping from around 154.98 to around 155.20. As of the time of writing, the exchange rate hovered around 155.05. The Bank of Japan had previously warned that due to factors such as government utility subsidies and the high base effect of the same period last year, the rate of price increase would fall. The authorities emphasized that they are more concerned about the potential level of inflation than one-off factors. Therefore, this data is not expected to shake the Bank of Japan's commitment to raising interest rates - the central bank will continue to push policy normalization through rate hikes as long as conditions allow. Most economists believe that the central bank is likely to take action in April at the earliest, and the possibility of adjusting interest rates at the next policy meeting on March 19 is relatively small. Taro Saito said: "I believe today's data will not change the Bank of Japan's stance on raising interest rates, but raising interest rates against the backdrop of cooling inflation means the central bank needs to communicate more cautiously." In its quarterly outlook report last month, the Bank of Japan stated that the core inflation rate in the first half of this year is likely to fall below 2%. Despite this assessment, the central bank raised its inflation expectations due to companies continuing to pass on cost increases to consumers, with the adjustment exceeding market expectations. Economist Taro Kimura said: "The cooling of inflation, coupled with implicit pressure to maintain easing following Kanon's victory in the early elections, means the Bank of Japan does not need to act hastily. We expect wage increases to continue to pass through to prices, leading to a rate hike by the Bank of Japan in July." As a key indicator of the sustainability of inflation, service prices in January rose by 1.4% year-on-year, unchanged from the previous month. Rice prices, which were a major driver of inflation last year, rose by 27.9% year-on-year, continuing to decline after reaching a historical increase of 101.7% in May. Food prices excluding fresh food rose by 6.2%, the slowest pace since March last year. High food prices have become a major political issue in Japan. Particularly before Kanon took office as prime minister in October last year, soaring consumer prices led to two major election defeats for the ruling Liberal Democratic Party. Last year, the proportion of Japanese household food spending reached its highest level in 44 years. To address this issue, after leading the Liberal Democratic Party to victory in the recent elections, Kanon reiterated her plan to suspend the consumption tax on food for two years. The impact of the utility subsidies introduced by Kanon is expected to further suppress inflation in subsequent data releases. SMBC Nikko Securities expects the core inflation rate excluding fresh food to slow to around 1.6% in February. Japanese authorities are closely monitoring whether the cooling of inflation will eventually lead to wage increases surpassing price increases, reversing the trend of declining real wages for several months last year. In theory, this will boost consumption and make inflation more sustainable. In the fourth quarter of 2025, Japan's economy grew by 0.1% quarter-on-quarter, and private consumption also increased by only 0.1%, well below market expectations. Saito said: "I believe underlying inflation is weakening, as companies have already significantly passed on costs, and now their willingness to raise prices has diminished. In addition, the yen has not continued to depreciate, which has also helped ease inflation."