Global: BOJ executive warns of ‘non-linear’ inflation spikes from external shocks

Japan’s experience with sharp inflation driven by higher import costs and exchange-rate shocks highlights the need for central banks to account for potentially “non-linear” price reactions when setting monetary policy, a Bank of Japan (BOJ) official has said.

The comments by BOJ Executive Director Koji Nakamura were made during a central bank-hosted monetary policy conference in May and published in conference notes on Monday.

Nakamura’s remarks underscore the BOJ’s concerns over persistent inflation risks that could require the central bank to continue raising interest rates as price pressures remain elevated.

The BOJ raised its benchmark interest rate to 1 per cent in June, its highest level in 31 years. The central bank is also expected to raise rates again this week, according to sources cited by Reuters, as monetary authorities globally respond to renewed inflation risks.

Supply shocks complicate monetary policy

Central banks traditionally increase interest rates to curb demand-driven inflation by slowing economic activity and borrowing.

However, the pandemic, Russia’s invasion of Ukraine, higher US tariffs and conflict in the Middle East have increasingly exposed economies to supply-side inflation, complicating the policy response.

During a panel discussion on how central banks should respond to supply shocks, Nakamura questioned whether recent disruptions had become more persistent and systematic.

According to the conference summary, he also pointed to factors such as income and wealth polarisation, populism, geopolitical risks and climate change as forces that could reinforce the effects of supply shocks.

Nakamura said that while central banks generally seek to “look through” temporary supply shocks, repeated disruptions should not automatically be treated as short-lived because they can influence underlying inflation and expectations.

Import and currency shocks can trigger sharp price increases

Japan’s experience demonstrates how external shocks can have stronger-than-expected effects on domestic prices, Nakamura said.

“Japan had observed non-linear reactions of domestic prices to external shocks, with consumer prices rising sharply in response to both import price and exchange rate shocks,” he was quoted as saying.

“Such non-linearities must be taken into account in the conduct of monetary policy.”

The comments highlight the challenge facing policymakers when external developments, such as currency movements and higher import costs, begin to feed through more quickly into consumer prices.

For Japan, the weakness of the yen has increased the cost of imported goods and energy, adding to inflationary pressures and complicating the BOJ’s efforts to maintain price stability.

Demographics add structural inflation pressure

Nakamura also identified Japan’s changing demographics as another source of persistent inflation pressure.

He described the shrinking labour force and resulting wage increases as a “slow-moving demographic shock” that could not simply be dismissed as a temporary development.

The BOJ executive said central banks should combine economic data with anecdotal evidence to better understand changes in the behaviour of households and businesses.

Such analysis, he added, could provide greater insight into how changing economic behaviour affects inflation expectations and ultimately the broader price outlook.

BOJ faces continued pressure to tighten policy

The BOJ ended its decade-long monetary stimulus programme in 2024 and has since signalled that further rate increases remain possible as economic conditions evolve.

A tight labour market, higher import costs linked to the weak yen and rising fuel costs associated with the Middle East conflict have increased the risk that inflation could exceed the BOJ’s 2 per cent target.

The latest comments from Nakamura reinforce the central bank’s focus on the persistence and transmission of inflation shocks as it considers the pace of future rate increases.

For the BOJ, the challenge is increasingly about distinguishing temporary disruptions from external shocks that can become embedded in domestic prices, wages and inflation expectations.