Japan inflation data shifts BoJ debate to where rates will peak

The focus of the debate is moving away from the timing of the BoJ's next hike and towards the ultimate peak for rates, a factor that has a significant bearing on the short end of the JGB curve. If markets shift from pricing a terminal rate of about 1.75% to one closer to or above 2%, it would probably push two- and five-year yields up following their recent advance. The yen strengthened after the data release, but for that to last it would likely require the BoJ to back a higher peak at its upcoming meeting, given the large trade deficit and the wide rate gap with the US. In equity terms, a higher-for-longer BoJ stance tends to be more beneficial for banks than for exporters. The main external driver remains oil: energy costs linked to the Middle East are adding to Japanese inflation despite the fuel subsidies, meaning crude above $110 a barrel keeps upside risk on both prices and the BoJ's projections.

• Japanese core inflation surpasses BoJ 2% goal for first time since December, yen strengthens

The breadth of Japan's inflation now makes a December BoJ increase appear to be the baseline assumption rather than the main uncertainty, leaving markets to focus on the ultimate peak for rates.

• Core CPI in Japan climbed to 2.1% in September from 1.7%, exceeding the BoJ's target for the first time in nine months. The measure excluding fresh food and fuel rose 2.4% from 1.9%.
• Goods inflation advanced to 2.8% from 2.6%, while services inflation edged up to 1.5% from 1.2%, suggesting firms are passing on higher labour costs.
• Higher fuel costs from the Middle East conflict, a weak yen and AI-driven demand are offsetting the effect of government fuel subsidies.
• The BoJ is expected to hold rates at 1.25% next week but may raise its inflation forecasts and say underlying inflation has likely reached 2%.
• Many analysts polled by Reuters expect a hike to 1.50% in December, with a terminal rate around 1.75% to 2%, and some see the risk of a higher peak.
• The flash PMI showed hiring slowing to a 14-month low, and the economy minister said conditions are not yet met to declare deflation over.

September saw an acceleration in Japan's underlying inflation, with price gains spreading across goods and services even though fuel subsidies remained in place. The figures reinforce the view that the BoJ will raise rates in December, and they are turning the spotlight onto the eventual peak for borrowing costs.

Core consumer prices (excluding fresh food but counting fuel) climbed 2.1% from a year earlier, matching projections and accelerating from a 1.7% gain in August. According to Reuters, this was the first time in nine months the number moved above the BoJ's 2% target. An index that discards both fresh food and fuel — the BoJ's preferred gauge of demand-pulled inflation — rose to 2.4% from 1.9%.

The details showed price pressures extending their reach. Goods inflation rose to 2.8% from 2.6%, while services inflation advanced to 1.5% from 1.2%, pointing to businesses starting to pass higher wages along to consumers. Higher fuel costs tied to the extended Middle East conflict, expensive imports from the weak yen, and robust demand related to AI have together countered the effect of the fuel subsidies.

Services inflation remains the vulnerable area in the picture. At 1.5%, it is a long way from 2%, underscoring that the wage-driven, domestically generated inflation the BoJ has pursued for a long time is building only slowly.

The BoJ is widely expected to hold its policy rate at 1.25% at its two-day meeting wrapping up on October 30, after lifting it to a 31-year peak in September. Sources told Reuters the bank might revise up its inflation forecasts, hint that underlying inflation has probably reached 2%, and emphasise its aim to keep inflation anchored there. Governor Kazuo Ueda said last week that the central bank would not accept inflation exceeding the target.

One economist speaking to Reuters said rising energy costs and their cascade effects should push core inflation higher, but prices are not accelerating sharply enough to justify back-to-back increases, making December his baseline call for the next move. A Reuters poll of many analysts showed a December expectation of a hike to 1.50%, with a terminal rate around 1.75% to 2%. Some see the risks as leaning higher. Capital Economics said there is little evidence that the tightening so far has slowed the economy down and that the policy rate might top its 2% forecast. Recent surveys show little sign that higher rates are weighing on loan demand.

Not every data point on Friday buttressed a more aggressive path. A flash business survey released the same morning showed private sector growth as steady but muted in October, with hiring slowing to a 14-month low and services companies reducing staff for the first time in over a year. Economy Minister Minoru Kiuchi said the government still lacks the required conditions to declare an official end to deflation, and he called on the BoJ to steer policy accordingly.

This leaves the BoJ with a familiar balancing act at its meeting next week: inflation that is at last becoming more widespread, set against signals that the labour market and domestic demand are giving up some momentum. The way the central bank characterises that balance in its outlook report seems likely to shape market expectations for the policy rate far beyond December.