BOJ warns inflation could rise well above target in risk scenario

By Leika Kihara

TOKYO, April 30 (Reuters) - The Bank of Japan ‌is projecting core inflation hovering ​around 3%, ​well above its 2% target, for two years in a row under a risk scenario of elevated oil prices and a weakening yen, highlighting the economy's vulnerability to an energy shock.

While BOJ said the risk of a wage‑price spiral remains limited for now, it warned ‌higher oil costs could increasingly feed through as firms more actively pass on raw material prices, a complete version of ⁠its quarterly report released on Thursday showed.

The rare release of a risk scenario highlights the challenge the BOJ faces in steering further interest rate hikes as the Middle East conflict muddles the ‌economic outlook.

"Economic and price developments could deviate considerably ‌from our baseline scenario depending on the future course of the Middle East situation. It is therefore necessary to thoroughly scrutinise various risk factors more than ever," it said.

The BOJ kept interest rates steady at 0.75% on Tuesday but sharply revised up its baseline inflation projections in a sign of ​its alarm over mounting price pressures.

Under the board's baseline scenario released on Tuesday, the central bank said it expects the core consumer price index (CPI) to rise 2.8% in the current fiscal year ending in March 2027 and by 2.3% the following year.

The scenario was based on the assumption the impact ⁠from the conflict will ease, and crude oil prices would decline from around $105 per barrel to around $70-80 toward the end of its three-year projection period through fiscal 2028.

In the full report released on Thursday, the ​central bank provided a risk scenario based on the assumption that oil prices remain at around $105 per barrel through the year-end, the yen weakens 10% from current levels and stock prices fall by 20%.

Under those assumptions, core inflation will ​hit 3.1% in fiscal 2026 and 3.0% in 2027 before slowing to 2.3% in 2028, ‌the BOJ said.

"It is especially notable that a rise of about 3% is expected for two years in a row in fiscal 2026 and 2027," the report said.

"This upward deviation in the CPI could become a factor that pushes up medium- ⁠to long-term inflation expectations," it added.

The BOJ has said it is watching closely whether the energy-led spike in prices feeds into inflation expectations and underlying inflation when deciding the timing of a rate hike.

DOWNSIDE GROWTH RISKS

With over 90% of its crude oil sourced from the Middle East, Japan's economy is acutely exposed to the effective closure of the Strait ⁠of Hormuz, a chokepoint for one-fifth of global oil and gas shipments.

Surging fuel costs from the conflict compound high import prices caused by a weak yen, intensifying inflationary pressure in ​an economy where inflation has exceeded the BOJ's target for four years.

The benchmark 10-year Japanese government bond (JGB) yield hit a 29-year high on Thursday as reports the U.S. is considering potential military action to end the Iran stalemate drove oil to a four-year high.

This week's hawkish split vote and unusually blunt signals of a near-term rate hike from the ‌BOJ have heightened the chance of the policy rate rising to 1.0% in June. But the decision could be complicated by the hit to growth from rising oil prices and supply disruptions.

Under the risk scenario, Japan's economy is expected to ‌expand 0.4% in fiscal 2026 before accelerating to 0.6% for both 2027 and 2028, slightly slower from the baseline projections.

Large-scale supply chain disruptions, which are not assumed in the risk ⁠scenario, would further dent growth and could cause a "nonlinear increase" ‌in inflation, the report said.

Rising oil prices will ​generate an income outflow equivalent to around 0.5% of Japan's gross domestic product (GDP) in fiscal 2026, with the ratio rising to 1.4% of GDP when accounting for price hikes for other oil-related goods, the BOJ said.

(Reporting by Leika Kihara; Editing by Muralikumar Anantharaman ‌and Shri Navaratnam)

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