Japan's unexpected decrease in inflation to its lowest level in nearly four years, but the easing of subsidies and soaring oil prices may make the 'cooling off' fleeting.

Key inflation indicators in Japan slowed more than expected, dropping to the lowest level in nearly four years, mainly due to the impact of utility subsidies lowering energy costs. However, the recent surge in oil prices may push inflation back up in the coming months. Data released by the Japanese Ministry of Internal Affairs on Tuesday showed that in February, the consumer price index excluding fresh food rose by 1.6% year-on-year, the smallest increase since March 2022. This data was below the median forecast of 1.7% by economists, and lower than the previous value of 2%. The core inflation index, which excludes energy to reflect potential inflationary strength, rose by 2.5%, well above the Bank of Japan's target of 2%. The overall inflation rate, including all categories, fell to 1.3%, the lowest since March 2022. The decline in energy prices widened to 9.1%, mainly driven by a drop in electricity prices. The rate of increase in food prices excluding fresh food slowed from 6.2% in January to 5.7% in February. Service prices, a key indicator of potential inflation, continued to rise by 1.4% year-on-year. The price of rice, which surged last year, rose by 17.1% in February, continuing to fall from the record 101.7% increase in May 2025. Taro Saito, director of economic research at the Japan Research Institute, said, "The biggest factor contributing to the slowdown in inflation is the government's utility subsidy measures. However, due to the impact of the Iran conflict, the core CPI is likely to rebound to around 2% in the next data release, overturning market expectations that inflation would stay below 2% in the period before the conflict." While the data shows a slight easing of inflation, consumers are already facing pressure from rising gasoline prices, which could continue to squeeze their cost of living for over four years. Japan's high dependence on imported energy makes it one of the most vulnerable economies to escalating tensions in the Middle East. Economist Taro Kimura said, "The core inflation index, excluding subsidy effects, remains well above the 2% target, indicating that the wage-price virtuous cycle remains strong and may be strengthened by the latest round of wage negotiations. This also keeps the Bank of Japan vigilant against potential price trends due to supply shocks, possibly leading to a rate hike in the short term." After the data was released, the yen weakened, with the USD/JPY exchange rate falling from around 158.35 at the time of the data release to 158.56. The yen exchange rate has been hovering near the 160 level, a level that has prompted government officials to intervene in the market multiple times in 2024. A weaker yen exacerbates inflationary pressures by raising import costs. Oil prices remained high on Monday, rising by about 50% from the levels before the outbreak of the conflict in Ukraine. As a result, gasoline prices in Japan have soared to their highest level since 1990. Against this backdrop, Bank of Japan Governor Haruhiko Kuroda hinted last Thursday that a rate hike at the next meeting in April is not ruled out, citing the need to consider both upward and downward risks to prices. Overnight index swap market pricing shows that traders are expecting a 63% probability of a rate hike. Economists had widely expected a slowdown in price increases in February, as Prime Minister Takanosae Takai resumed utility subsidies for a three-month period starting in January. The impact of these measures began to show in the data released on Tuesday. The government also reinstated gasoline subsidies last week in an effort to keep gasoline prices controlled at 170 yen per liter, after gasoline prices had risen to a record high of 190.8 yen per liter. Given Japan's status as the country with the highest public debt burden globally, investors are closely watching how long Prime Minister Takai will maintain energy subsidies and what additional measures may be implemented. Takai's commitment to addressing the cost of living crisis through fiscal means won overwhelming support in last month's election. Analysts at JPMorgan Securities wrote in a report last week that if oil prices remain around $100 per barrel by the end of April, the deflationary effect of government measures may only be temporary, and the core inflation index in Japan, excluding fresh food, could accelerate to around 2.5% by May. Taro Saito said, "The trend of CPI data also depends on the government's response measures. Unless the government takes action, the cost of living will continue to rise as long as the conflict persists."