Japan entered 2026 with a sense of optimism. Wage growth was at historic highs, headline inflation was beginning to ease, and policymakers dared to speak of a new economic equilibrium—better wages, higher prices, and a long-overdue escape from deflation.
Then the Middle East exploded, oil prices surged, and the Bank of Japan found itself navigating a narrowing path between tightening too fast and falling dangerously behind. In an interview with Japan Forward, Shigeto Nagai, chief economist at Oxford Economics Japan, explained where things stand.
Rate Hikes Expected in June
It was revealed on June 9 that the Bank of Japan (BOJ) is preparing to raise its policy rate from around 0.75% to approximately 1.0%.
Nagai says that a June hike is 99% certain. The BOJ’s two-day policy meeting is scheduled for June 15–16, with markets currently pricing an 80–96% probability of a hike to 1%—which would be the first time rates have reached that level since 1995.
At its previous meeting in April, the BOJ kept its policy rate steady, although three dissenters called for an immediate move to 1%.
To Nagai, that split reflected a divergence—not just on timing, but on institutional priorities. The dissenters were external board members; the majority included the governor and his deputies.
“The external board members tend to focus almost purely on getting monetary policy right,” he explained. “The executive—the governor and his deputies—also factor in the government relationship, political pressures, and the longer-term question of institutional credibility. Under Prime Minister Takaichi, who has been very cautious on rate hikes, that pressure was real and tangible.”
By June, however, the calculus had shifted. Governor Kazuo Ueda’s speech to the Kisaragi-kai research group sent an unambiguous signal that a hike was coming. By then, the yen had been sliding toward 160 to the dollar, and with US Federal Reserve rate-cut expectations flipping toward hikes, the pressure for further weakness was mounting.
Nagai said the speech effectively locked the BOJ in—once Ueda had signaled so clearly that a hike was coming, the risk of then failing to deliver had become greater than the risk of moving despite the uncertain economic environment.
“This rate hike is, at its core, defensive—a move to prevent yen depreciation from deepening the terms-of-trade shock Japan is already absorbing.”
How High Can Rates Go?
On the terminal rate, Nagai pushed back against those projecting 1.75% as a consensus endpoint. “Different surveys give you different answers—many BOJ watchers still cluster around 1.5%,” he said. “And academic estimates of the neutral rate range from 1% to above 2%. The honest answer is nobody knows.”
Governor Ueda, he noted, has been explicit about this uncertainty, ruling out any mechanical approach of targeting a predetermined level. “He’ll watch how bank lending rates, long-term bond yields, equity markets, and real economic activity respond to each hike, and calibrate from there,” Nagai said. “That pragmatism is exactly right.”
The key variables, he explained, are Japan’s potential growth rate—still likely around 0.5%, in his view—and the degree to which inflation expectations have genuinely become re-anchored. Both determine the level at which the neutral rate sits. “We at Oxford Economics think 1.5% is probably the ceiling—but that can only be confirmed by proceeding gradually and watching how the economy responds.”
The Mini-Stagflation Problem
On the impact of the Middle East situation, Nagai was direct: Japan is already in what he calls a “mini-stagflation.” The BOJ’s own forecasts cut the FY2026 growth outlook in half—from 1% to 0.5%—while lifting core inflation to 2.8%. Real wages are being squeezed, household consumption is soft, and the terms-of-trade shock is falling hardest on those least able to absorb it.
“It’s not 1970s-style hyperinflation or a deep recession,” he clarified. “But it’s a prolonged period where inflation stays above 2%, real incomes stagnate, and growth disappoints. That’s the mini-stagflation—and it’s already here.”
Subsidies and Their Limits
In this context, he was critical of the government’s approach to energy subsidies. Prime Minister Takaichi, he noted, has been aggressive in shielding consumers from price rises through fiscal transfers.
Most economists disagree with this, Nagai among them. “Price signals exist for a reason—they suppress demand when supply is short. Subsidies that switch off those signals are not good economics, and they’re expensive at a time when Japan’s fiscal position is already under pressure.”
The deeper concern is fiscal dominance. With Japan’s 10-year bond yield hovering around 2.7–2.8%, and the government preparing a supplementary budget, Nagai warned of a slow-building conflict between fiscal and monetary policy. “If the BOJ feels it has to go easy on rate hikes to protect the government’s borrowing costs, credibility erodes, term premiums rise, and long-term rates climb further. That’s the fiscal dominance trap. We’re not there yet—but the risk is growing.”
The Fault Line in the Wage Story
Japan’s wage renaissance, Nagai argued, remains real but uneven. Large corporations, with strong balance sheets and overseas earnings cushioned further by yen weakness, have the capacity to keep raising wages. The structural driver—severe labor shortages forcing firms to compete for workers—has not gone away.
The risk is in the small and medium-sized enterprise sector, which accounts for nearly 70% of Japanese employment. These firms are more vulnerable to energy cost shocks, have thinner margins, and are less able to pass costs through to customers. “If the Middle East conflict drags into 2027,” Nagai said, “it’s the SMEs where wage growth will slow first. And that’s where the shadow falls on Japan’s new growth narrative.”
RELATED:
Bank of Japan Announces First Rate Hike in 17 Years
Author: Daniel Manning
Continue Reading