Yen trend dramatically shifts! Japan's inflation data surprises, changing the outlook for the central bank's rate hike

At the end of the month, the Asia-Pacific market will see important data—Japan’s Tokyo inflation unexpectedly cooled significantly, directly impacting the yen exchange rate and changing market expectations for the Bank of Japan’s next policy move. According to the latest data released by Japan’s Statistics Bureau, the core consumer price index (excluding fresh food) in the Tokyo area rose 2.3% year-on-year in December, an unexpected decline from 2.8% the previous month, far exceeding economists’ forecast of 2.5%. This result immediately pushed the yen weaker, with the USD/JPY exchange rate reaching 156.49 at one point, nearly 1 point higher than before the data release.

Tokyo Inflation Data Surprises, Food and Energy Pressures Significantly Eased

This decline in Tokyo inflation marks the first drop since August, mainly reflecting the fading delayed effects of last year’s energy subsidies ending. Not only has core inflation cooled, but overall inflation also decreased from 2.7% in the same period two years ago to 2%, while deeper inflation indicators (excluding energy) slowed to 2.6%.

Market analysis generally believes that prices for goods, services, and food have all slowed in tandem, with a notable shift in the food sector. According to Koya Miyamae, senior economist at SMBC Nikko Securities, “This result is indeed weaker. After sharp price increases, some food sellers have started lowering prices in response. In a demand-stagnant environment, retail stores are also launching promotional strategies.” This reflects that, under the expectation of slowing economic growth, pricing power is shifting into consumers’ hands.

Tokyo inflation data is usually seen as a leading indicator of nationwide inflation trends. Its unexpected decline immediately prompted a reassessment of the Bank of Japan’s next steps.

Yen Weakens, Market Reprices Policy Expectations

Following the inflation data release, the yen weakened, directly reflecting market adjustments in expectations for the BOJ’s rate hike pace. Last week, the Bank of Japan’s Policy Board unanimously voted to raise the benchmark interest rate to 0.75%, the highest level since 1995. However, BOJ Governor Kazuo Ueda stated at a subsequent press conference that policy tightening would depend on whether inflation prospects materialize as expected, without providing clear guidance on the pace or terminal rate of hikes.

The unexpected softening of inflation data has directly changed market pricing. Traders are now betting that the BOJ may delay the next rate hike, which has driven the yen lower. USD/JPY has hovered near its lowest levels since January, reflecting the continued pressure from narrowing U.S.-Japan interest rate differentials.

Central Bank Policy Faces Dilemma, Inflation Still Above Target

Despite the cooling inflation data, Tokyo core inflation remains above the BOJ’s 2% target, giving the central bank reason to continue tightening policy. The latest policy statement projects that inflation will gradually reach the target in the latter half of the forecast period, through fiscal year 2027.

This presents a clear policy dilemma: on one hand, inflation remains high and has not returned to target; on the other, economic data is weakening, and inflation is slowing faster than expected, limiting room for further rate hikes. A Bloomberg survey of economists shows market expectations that the BOJ will raise rates roughly every six months, with a terminal rate around 1.25%. This suggests analysts believe the current cycle will see about two more rate hikes.

Market Expectations Adjust, Semiannual Rate Hikes Become New Consensus

Based on the softening inflation data and the BOJ’s cautious stance, the market has begun to build a new rate hike expectation framework. Compared to previous expectations of more frequent hikes, a six-month interval has now become the new market consensus. This more moderate rate hike path will extend the overall policy normalization cycle.

Ueda has hinted that further rate hikes could be implemented if necessary, and the U.S.-Japan interest rate differential is expected to gradually narrow, theoretically supporting yen appreciation. However, market caution about future rate hike progress has instead suppressed the yen, indicating that the market is more focused on the delay of near-term policy moves rather than the long-term convergence of interest rate differentials.

Rising Import Costs, Official Prepared for Intervention

Another risk of the yen’s continued weakness is rising import costs. As the yen depreciates, import prices are under upward pressure, which could eventually pass through to domestic prices and conflict with the BOJ’s inflation target.

In response to the risk of excessive yen depreciation, Japanese authorities have signaled strong readiness to intervene in the foreign exchange market if necessary. Recent statements from Japan’s financial regulators and BOJ officials indicate preparedness to step into the market to stabilize the yen. This reflects concerns over the yen’s excessive weakness and efforts to prevent import cost pass-through.

The inflation data released at the end of the month has undoubtedly become a market turning point. With inflation unexpectedly falling, policy space limited, and the yen remaining weak, Japan’s economic outlook faces new challenges. Future market focus will shift to whether the BOJ will truly follow the new expectations to raise rates and whether the yen’s movement will trigger official intervention.