First time in 15 months! Tokyo’s CPI falls below the 2% target, but the Bank of Japan’s rate hike path remains undeterred.

Japan's capital inflation unexpectedly cooled, but analysts believe this slowdown is unlikely to halt the Bank of Japan's further tightening of monetary policy.

Data released by Japan's statistics department on Friday showed that the Tokyo area’s consumer price index (CPI) excluding fresh food rose 1.8% year-on-year in February, lower than January’s 2.0%, and marked the first time since October 2024 it fell below the Bank of Japan’s 2% policy target. The main reason for this cooling is the government's resident living subsidy policy, which led to a 9.2% year-on-year plunge in energy prices.

However, several economists have pointed out that underlying inflationary pressure excluding energy factors remains robust, and service prices, highly correlated with wage growth, continue to rise. Overall, this data does not change the market’s assessment of the Bank of Japan’s monetary policy direction.

Current market pricing shows the probability of the Bank of Japan raising interest rates in April is close to 60%, according to data from Tokyo money market brokers. Retail sales and industrial production data released the same day also indicate overall resilience in the Japanese economy, further supporting the rate hike path.

Energy subsidies dominate cooling, core inflation still supported

This decline in Tokyo’s CPI did not stem from shrinking demand or a reversal of inflation trends, but mainly reflects the technical suppression from government subsidies.

Data show that energy prices fell 9.2% year-on-year in February, which is the key variable dragging down overall CPI. The core inflation index excluding fresh food and energy actually rose higher, increasing from January to February at 2.5%, indicating that potential price pressure has not dissipated.

Takuya Hoshino, economist at Dai-ichi Life Research Institute, assessed Tokyo’s data as “overall robust”, and especially pointed out that service prices rose 1.5% year-on-year, a slight increase over January. Service prices are closely linked to wage increases and are an important indicator for the Bank of Japan in judging the sustainability of inflation.

Hoshino said that although CPI excluding fresh food continues to slow, “This result is unlikely to prevent the Bank of Japan from further raising interest rates.”

Path of rate hike unchanged, April window approaching

Several economists and market participants agree that the Bank of Japan’s policy normalization process has not been materially impacted by this bout of inflation cooling.

Marcel Thieliant, economist at Capital Economics, said that a series of economic indicators published on Friday (including inflation data) taken together “suggest the Bank of Japan will not wait too long to raise rates again.”

After the Bank of Japan raised its policy rate to 0.75% last December, it has maintained a cautious but positive inclination toward raising rates. Currently, traders and BOJ officials are closely monitoring consumption tax reduction measures planned by Prime Minister Sanae Takaichi, assessing their potential impact on future price trends.

Consumption and production data support economic resilience

Other economic data released on the same day overall show a robust consumption side and a warming production side.

Japan’s retail sales in January rose 1.8% year-on-year, showing sustained consumption momentum. Industrial production in January increased 2.2% month-on-month, reversing a 0.1% decline in December, partly due to demand for inventory stocking before the Lunar New Year holiday.

However, short-term warming does not mean concerns have disappeared. Friday’s data also showed that factory activity is expected to weaken again over the next few months. If manufacturing sector weakness drags down broader economic growth, it will somewhat weaken the justification for raising rates.

Internationally, Japan’s manufacturing faces external pressure from two directions, adding uncertainty to the economic outlook.

Although the U.S. Supreme Court recently overturned so-called tariff reciprocity measures, Japanese officials warn that tariffs on the auto industry continue to drag down related sectors, and say they will continue to monitor the actual impact of new tariff policies from the Trump administration. Policymakers believe that despite headwinds from trade policy, Japan’s corporate sector overall remains resilient.

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