Japan's consumer price inflation slowed further in February, falling short of expectations, but the Bank of Japan is likely to ignore the recent slowdown in inflation and continue to focus on the upside risks to prices.

Healthy wage negotiations and a stronger-than-expected Purchasing Managers' Index (PMI) have increased the likelihood of an April rate hike. However, the final timing still depends on developments in the Middle East.

Government utility subsidies led to a significant drop in inflation in February.

Japan's Consumer Price Index (CPI) rose 1.3% year-on-year in February, lower than January's 1.5% and the market consensus, representing a larger-than-expected slowdown. The main reasons for the overall decline in inflation were a 4.5% drop in fresh food prices and a 5.5% drop in utility prices. Seasonally adjusted, the CPI fell 0.2% month-on-month in February. Goods prices fell 0.6% month-on-month, while services prices rose 0.1%.



Despite lower-than-expected actual inflation data, the Bank of Japan is unlikely to place too much emphasis on this short-term slowdown, as it is primarily driven by government utility subsidies. The Bank of Japan will focus more on the underlying inflation trend excluding food and energy prices. The "core core" inflation rate, excluding food and energy, fell slightly to 2.5% in February (previous value 2.6%, in line with market expectations), but remains significantly above the Bank of Japan's target level of 2.0%.

Overall inflation is expected to remain below 2% in the coming months, while core inflation will remain sticky.

Despite the sharp rise in gasoline prices, the overall CPI year-on-year increase is expected to remain below 2% in the coming months due to the government's fuel price cap policy. Meanwhile, the base effect will continue to suppress inflation readings. However, core inflation is expected to remain at a sticky level of around 2.5%.

With the positive results from the initial stages of wage negotiations this spring, we believe that demand-side inflationary pressures will remain intact.

The initial results of the wage negotiations are encouraging.

Rengo, Japan's largest labor union, announced that average wages will increase by 5.26% this year, slightly lower than the initial increase of 5.46% in the same period last year. This figure will be revised several times later (such as on March 27 and April 3). It is worth noting that the situation in the Middle East has had a very limited impact on wage negotiations so far.

Bank of Japan Governor Kazuo Ueda has previously emphasized that policymakers are closely monitoring whether wage increases will effectively cover small and medium-sized enterprises (SMEs). Many SMEs will finalize wage agreements in April, making this development a key focus for the market, with the final results expected before the Bank of Japan's April meeting.

Although the preliminary PMI reading declined, it remained in expansionary territory.

Japan's preliminary manufacturing Purchasing Managers' Index (PMI) fell to 51.4 in March from 53 in February, with both output and new orders declining. The preliminary services PMI also fell to 52.8 from 53.8 in February.

This decline is believed to primarily reflect the impact of recent global oil supply shocks and reduced new orders, increasing market concerns about the economic outlook. However, both PMI indices remain above 50, indicating that businesses generally believe the current geopolitical risks are temporary, and overall business confidence remains positive.

The Bank of Japan will ignore short-term inflation fluctuations and continue to raise interest rates.

The Bank of Japan will continue its interest rate hike process. The exact timing remains uncertain, and it is expected to be between April and June, but we now believe that the probability of a rate hike in April is slightly higher than in June.

Sticky core inflation, stronger-than-expected PMI data, and a positive start to spring wage negotiations have all increased the probability of an April rate hike.

The development of the situation in the Middle East is considered a key variable in policy decisions. If the situation in the Middle East can be stabilized as soon as possible, and there are no signs of a significant decline in production or consumption, the likelihood of an interest rate hike in April will increase further.

Overall, despite the unexpected decline in February's CPI data, the Bank of Japan's focus remains on underlying inflation trends, the sustainability of wage growth, and economic resilience. As long as the situation in the Middle East does not deteriorate further and significantly drag down Japanese economic activity, the probability of a rate hike by the Bank of Japan in April remains relatively high. The market needs to continue to monitor the final outcome of subsequent wage negotiations and changes in geopolitical dynamics.