Japan: Inflation at a two-year low – How soon Will the BoJ hike rates?

Japan’s latest inflation data has complicated the outlook for monetary policy. Price growth has slowed to its weakest pace in two years, just as markets were positioning for another rate increase from the Bank of Japan (BOJ). For traders and analysts, the debate is now about timing and what signals the central bank is prioritizing.

Inflation cools to target (and below)

Government data released on Friday showed that core inflation — which excludes volatile fresh food prices — rose 2.0% year-on-year in January 2026. That matched market expectations and slowed from December’s 2.4% pace, marking the lowest reading since January 2024.

Headline inflation decelerated more sharply, falling to 1.5% from 2.1% in December. This is the first time in nearly four years that overall inflation has dipped below the BOJ’s 2% target, a development that creates communication challenges for a central bank that has just exited ultra-loose policy.

Even so, underlying pressures remain firmer. The so-called “core-core” measure — which excluded both fresh food and energy — stood at 2.6%. While down from 2.9% in December, it is still comfortably above 2%.

Much of the deceleration in price growth is attributable to one-off factors. January's data was likely pulled lower by government fuel subsidies, the removal of gasoline tax surcharges, and the high base of comparison following last year's spike in food prices. Energy costs have also eased, helping to reduce headline inflation.

The BOJ has previously signaled that it expects such one-off effects to temporarily push inflation below target in early 2026. CNBC wrote that in its latest outlook (January), the central bank projected that year-on-year consumer price growth is likely to fall below 2% in the first half of fiscal 2026 (which begins April 1), before stabilizing. At the same time, it modestly upgraded its inflation forecasts for fiscal 2026, projecting core inflation at 1.9% (up from 1.8% in October 2025) and core-core inflation at 2.2% (up from 2.0%).

But rather than focusing on short-term volatility, the Bank of Japan is likely to focus more on whether Japan achieves durable, wage-driven inflation around 2%.

A tightening cycle potentially paused

The January data comes after a significant policy shift. In 2024, the BOJ ended its decade-long massive stimulus program and gradually raised its policy rate, reaching 0.75% in December 2025 — the highest level in 30 years. At that time, it signaled readiness to continue tightening if conditions allowed.

Despite the latest slowdown in inflation, upside risks have not disappeared. A weak yen continues to increase import costs, and expansionary fiscal policy may add to demand pressures. These conflicting forces — cooling energy prices on one side and currency-driven import inflation on the other — complicate the near-term outlook.

A Reuters survey published on February 19 showed that a majority of economists now expect the BOJ to raise its key rate to 1% by the end of June 2026, with some anticipating a move as soon as April. Markets have priced in roughly a 70% probability of an April hike. This represents a shift forward from earlier expectations that had pointed to a move around end-September.

Norihiro Yamaguchi of Oxford Economics argues that the slowdown in headline inflation is unlikely to derail the hiking path. In his view, the BOJ may wait until June, allowing policymakers to assess the outcome of this spring’s wage negotiations before moving to 1%.

Beyond inflation dynamics, higher rates could also produce unintended liquidity effects.

Ikuko Samikawa of the Japan Center for Economic Research notes that historically, when the policy rate exceeds 0.5%, households tend to shift funds from cash into interest-bearing bank deposits. If the rate rises to 1%, such inflows could accelerate.

Higher deposit levels would expand liquidity within the BOJ’s current accounts, potentially exerting downward pressure on money market rates through increased supply. In that scenario, guiding short-term rates precisely around the policy target could become more operationally complex.

Upcoming changes in the BoJ board could also shape monetary policy direction

Japan’s government is expected to submit nominees around February 25 to replace two outgoing board members. The selections made by Prime Minister Sanae Takaichi — who secured a landslide election victory on February 8 — will be closely scrutinized by markets for signals about the administration’s tolerance for further tightening.

The nine-member board has gradually shifted in favor of steady rate increases. However, changes in composition could influence the pace and tone of future discussions. Looking further ahead, Governor Kazuo Ueda and his deputies’ terms expire in 2028, meaning the longer-term direction of policy could ultimately depend on political continuity.

Still, some advisers have suggested that appointing outspoken reflationists may not be necessary, given that Japan has already exited deflation.

Bottom Line

Japan’s inflation has cooled to a two-year low, but the broader normalization process appears intact. Core measures remain near target, and wage developments will be central to confirming whether inflation can be sustained without support. Markets currently lean toward a rate increase to 1% by June, with April remaining a live possibility. What about you?