Japan Is Being Forced to Turn Off the Money Spigot

Japan’s central bank will likely be forced to raise rates slightly faster than markets anticipate, as a country that imports 95 percent of its crude grapples with high fuel prices.

The move will ripple through global markets as there is no real alternative to Japan as the main source of cheap capital.

On Friday, the Nikkei 225, Japan’s best-known stock benchmark, fell 6 percent, entering bear-market territory. Similar gauges in South Korea, Australia and Hong Kong fell too, as did mainland China’s CSI 300. The slide followed heavy selling on Wall Street, where the three major stock indexes posted their worst one-day performances since April 2025.

A big reason for the selling was expectations that the Federal Reserve will be compelled to raise rates, and do so quickly, to catch up with inflation.

On Thursday, the Bank of England raised its key rate by 0.25 percentage points to 4 percent due to rising energy prices from the conflict in the Middle East. “Inflation has risen to 3.5% and we expect it to rise even further to about 5% by the middle of 2027 as higher energy prices have their knock-on effects; higher bills could force businesses to increase their prices to cover the cost, for example,” it said.

“Energy costs have been high for long enough now that we expect those knock-on effects to eventually kick in,” the Bank of England said. “The economy has been more resilient and activity has been stronger than expected – this is good news, but it adds to the risk that higher energy prices affect other prices and wages; so, we must act now to reduce their impact.” Raising rates now would limit “how far higher energy costs feed into prices in the economy more generally.”

The U.K. central bank’s reasoning will likely add pressure on the Fed, which has so far taken a wait-and-see approach to rising prices, after midterm elections in which Democrats won the Senate and the House. A majority of voters cited rising prices as a top concern, Reuters reported.

“...we must act now to reduce their impact.”

Bank of England

Boxed in a Corner

The Bank of Japan left its policy rate at 1.25 percent on Oct. 30, with one board member voting for an increase to 1.5 percent, amid Brent crude at $118 a barrel that day and the yen at 157.5 to the dollar.

Three days later, the Institute of International Finance (IIF), a financial-industry trade group, said its model sees the Japanese central bank raising rates in December, March and June, which would lift the policy rate to 2 percent by the middle of 2027.

That is slightly ahead of the market.

Overnight index swaps price about 1.9 percent for September 2027, and private forecasters see between 1.75 percent and 2.25 percent at the end of that year, with a consensus near 1.8 percent.

The path matters because of oil.

About 95 percent of Japan’s crude comes from the Middle East, and roughly 70 percent of it passed through the Strait of Hormuz before the conflict began, AFP reported in March. Japan is the fifth-biggest crude importer. The war with Iran is now in its ninth month, according to The National. Japan took the first blow through lower fuel use, drawn-down stockpiles and energy subsidies. The institute says the cost now passes through the yen, wages and the Bank of Japan.

Holders of yen and Japanese government bonds have seen what the strain looks like.

The 10-year yield rose as high as 2.87 percent in the first week of August, Reuters reported. Tokyo spent 11.7 trillion yen ($72.52 billion) between late April and May to defend the currency, a record monthly amount, according to a Reuters factbox. Over July 30 and 31 it pushed the yen from 163 to about 157, including a joint operation with the United States on the 31st, the first coordinated action since 2011, the same factbox said. By Aug. 5 the yen had drifted back to 157.6, Reuters reported. On Oct. 30 it was 157.5.

Chart

The rule points to 2% by mid-2027

Bank of Japan policy rate, %, with IIF model

Desired rate, rulePolicy rateIIF model pathOIS-implied path

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Bank of Japan policy rate and IIF model

Date	Policy rate, %	IIF model path, %	OIS-implied, %	Desired rate, rule, %
24	−0.10	n/a	n/a	n/a
25	0.25	n/a	n/a	2.02
26	0.75	n/a	n/a	2.25
27	n/a	1.50	1.46	2.26
28	n/a	2.00	n/a	1.82

Values at the start of each year, read from the chart; approximate.

Energy Support Hid the First Round

Core inflation, which excludes fresh food, was 2.1 percent in September. Electricity and gas support and a gasoline price cap held it about 0.9 point below where it would otherwise have been, by the institute’s estimate.

That reverses in the new year.

Last winter’s support drops out of the annual comparison just as higher fuel import costs reach electricity bills, which they do with a lag of four to six months. The model has core inflation rising to about 4 percent in the first quarter of 2027 and about 4.3 percent in February. If the government repeats last winter’s support, the first quarter holds near 3.3 percent.

The bank is likely to look through the swing, the report says. Underlying inflation, which also excludes energy and the food tax cut, is the better guide.

Chart

Energy bills push core inflation near 4%

Core and underlying CPI, % year on year, IIF model

Core CPIUnderlyingUnderlying (model)Core, support repeatedCore, baseline

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Core and underlying CPI

Date	Core CPI, %	Underlying, %	Underlying (model), %	Core, baseline, %	Core, support repeated, %
24	2.2	3.5	n/a	n/a	n/a
25	2.9	2.5	n/a	n/a	n/a
26	1.9	2.5	n/a	n/a	n/a
27	n/a	n/a	2.6	3.3	3.0
28	n/a	n/a	2.5	1.2	1.5

Values at the start of each year, read from the chart; approximate.

Crude imports fell about 60 percent in April and May, and liquefied natural gas imports about 18 percent. Coal imports rose about 11 percent in May and June, enough in energy terms to replace about half of the lost gas in power generation. Crude stocks were 22 percent below a year earlier by April and had been rebuilt by August. Prime Minister Sanae Takaichi had said in March that Japan would release 15 days of private reserves and a month of national reserves, AFP reported. Real GDP still grew at annualized rates of 1.9 percent and 1.4 percent in the first two quarters, though lower fuel imports raised the measured figure, and domestic demand subtracted 0.4 point in the second.

The Yen Is Now Doing Three Times as Much

The yen reaches inflation through import prices, and the institute’s estimates say it now passes into prices more strongly than before 2020. Since 2021, a lasting 10 percent rise in the dollar-yen rate has raised underlying inflation by up to about 0.9 point, about three times the effect before 2020 once consumption tax increases are set aside. The effect builds from about six months, peaks after 15 to 18 months and fades over the following year. It leaves the price level about 1.15 percent higher. Before 2020 the figure was 0.35 percent.

Chart

Yen pass-through is three times larger

Price level, % rise, by quarter after a 10% rise in USD/JPY

Since 2021Before 2020

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Yen pass-through

Quarters after the rise	Since 2021, %	Before 2020, %
0	0.00	0.00
1	0.00	0.00
6	1.15	0.35
12	1.15	0.35

The 1.15% and 0.35% end values are the IIF’s; the path between quarters 1 and 6 is a straight line drawn for this chart.

Prices respond mainly to a falling yen. A weak but stable one adds little to inflation by 2028. A further 5 percent fall early next year would lift underlying inflation to about 2.5 percent in 2028, or about 2.3 percent if Brent stays near $115.

The currency has little support from interest rates. The institute’s fit of the yen to the gap between U.S. and Japanese two-year yields from 2021 to 2024 puts the exchange rate at about 130 per dollar on Oct. 30. The same fit through 2026 gives about 137. Both fall inside its fair value range of 125 to 138, which it derives from the current account. At 157.5, the yen stood about 21 percent above the first benchmark.

Chart

The yen is far weaker than rate gaps imply

USD/JPY, yen per dollar; higher is a weaker yen

USD/JPYUSD/JPY, IIF forecastImplied by rate gap, fit to 2024Implied by rate gap, fit to 2026

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USD/JPY and rate-gap benchmarks

Date	USD/JPY	Implied, fit to 2024	Implied, fit to 2026
21	105	109	117
22	115	117	124
23	131	144	154
24	147	144	151
25	151	136	142
26	156	126	133
27	155	n/a	n/a

Values at the start of each year, read from the chart; approximate.

The baseline lets that premium fade slowly, toward about half of today’s level, so most of it remains at the end of 2027 and the yen firms only to about 155, weaker than the consensus of about 150. If the bank stopped at 1.75 percent, the yen would stay near 158. With a higher risk premium it would reach about 162, a level the report says could raise the risk of official intervention.

“The yen remains well below estimated fair value, leaving a risk that import price pressure requires more tightening than we forecast.”

IIF report, Nov. 2

Wages Keep the Floor High

Scheduled earnings rose 3.8 percent in August, or 2.9 percent for full-time workers in the same sample of firms. In the institute’s estimates, each extra point of wage growth goes with about 0.4 point more underlying inflation. The baseline has wages adding about 1.4 points to underlying inflation in 2027, and the yen about half a point in the first half of the year.

Chart

Wages and the yen sustain inflation into 2027

Contributions to underlying inflation, percentage points, IIF model

WagesYenOutput gapConstant and otherUnderlying inflation, %

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Contributions to underlying inflation

Quarter	Wages	Yen	Output gap	Constant and other	Underlying, %
2024 Q1	0.50	1.70	0.50	0.45	3.14
2024 Q2	0.58	1.21	0.37	0.10	2.26
2024 Q3	0.69	0.94	0.00	0.34	1.99
2024 Q4	0.82	0.92	0.00	0.60	2.35
2025 Q1	0.82	0.86	0.10	0.88	2.66
2025 Q2	0.82	0.82	0.24	1.30	3.19
2025 Q3	0.78	0.78	0.23	1.42	3.21
2025 Q4	0.73	0.33	0.29	1.61	2.97
2026 Q1	0.90	0.00	0.28	1.25	2.44
2026 Q2	1.03	0.00	0.30	0.50	1.82
2026 Q3	1.21	0.00	0.17	0.70	2.05
2026 Q4	1.36	0.12	0.27	0.73	2.49
2027 Q1	1.39	0.47	0.24	0.72	2.83
2027 Q2	1.40	0.55	0.17	0.86	2.99
2027 Q3	1.36	0.50	0.12	0.88	2.86
2027 Q4	1.31	0.38	0.11	0.87	2.68
2028 Q1	1.28	0.09	0.09	0.89	2.35
2028 Q2	1.27	−0.09	0.08	0.85	2.11
2028 Q3	1.25	−0.16	0.06	0.87	2.02
2028 Q4	1.24	−0.16	0.04	0.86	1.99

Percentage points; read from the chart and approximate.

Underlying inflation peaks near 3 percent in the first half of next year, averages 2.9 percent in 2027 and settles near 2.1 percent in 2028.

Officials and market participants in Tokyo saw scope for faster tightening, the institute says. In the model, getting the policy rate to 2.25 percent would need scheduled earnings growth of about 4.5 percent next year. Against that, softer demand and a fading yen effect argue for a hold after mid-2027.

December is the test of that pace.

The model assumes the bank keeps this year’s quarterly rhythm, which leaves a meeting between increases and fits a senior official’s warning against back-to-back moves. A rule that moves every second quarter tracks 2024 and 2025 closely, skips December and stops at 1.75 percent in the third quarter of 2027. If the bank stopped there, underlying inflation would still be near 2.3 percent in 2028, or near 2.5 percent if investors also added about 3 percent to the yen risk premium, against about 2.1 percent in the baseline.

“A pause in December would point to a stop at 1.75%.”

IIF report, Nov. 2

Chart

A stop at 1.75% keeps inflation higher for longer

Underlying inflation, % year on year, IIF model

ActualBaseline, BoJ to 2%BoJ stops at 1.75%Stops at 1.75%, higher risk premium

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Underlying inflation under three Bank of Japan paths

Date	Actual, %	Baseline, %	Stops at 1.75%, %	Stops, higher premium, %
24	3.2	n/a	n/a	n/a
25	2.6	n/a	n/a	n/a
26	2.5	n/a	n/a	n/a
27	n/a	2.8	2.8	2.8
28	n/a	2.4	2.5	2.7

Values at the start of each year, read from the chart; approximate.

A Tax Cut on Top of an Expansionary Budget

Japan’s cabinet signed off on Aug. 5 on Takaichi’s flagship plan to cut the consumption tax on food to 1 percent from 8 percent for two years from April 2027, with a benefit payment equal to the remaining 1 percent that would effectively remove the tax from food purchases, Reuters reported. It would be the first cut since the tax was introduced in 1989. Reuters put the revenue shortfall at roughly 5 trillion yen. Jiji Press later reported a cost of some 10 trillion yen over the two years for the tax cut and an income-linked benefit program together. The institute’s own figure is 4 trillion to 5 trillion yen a year, which it adds to what it calls an already expansionary fiscal stance.

“To maintain market confidence, we will secure the resources needed (to fund the tax cut) without relying on deficit-financing bonds, through a comprehensive review of both expenditures and revenues, including subsidies and tax breaks,”

Finance Minister Satsuki Katayama, to reporters, as reported by Reuters

The cabinet adopted the bill on Oct. 9. The government wants it enacted by Dec. 12, when the extraordinary Diet session ends, Jiji Press reported. If it passes, the institute says, it lowers core inflation by about 1.1 points for a year from April, to about 2.6 percent in 2027. The bank is likely to look through that swing as well.

The Forecast Leans on Oil Coming Down

The baseline has Brent averaging $84 in 2027. Brent was $118 on Oct. 30. It averaged $68 in 2025, and the institute puts 2026 at $94.

If Brent stayed near $115 through 2027, growth would fall to about 0.4 percent and the current account surplus to about 3.8 percent of GDP. On the futures curve, which averages about $99 in 2027, growth would slow to about 0.5 percent and the surplus to about 4.2 percent. The baseline has growth slowing from 0.9 percent in 2026 to 0.6 percent in 2027, against a consensus of 0.8 percent. At $115, core inflation would rise about 0.2 point in 2027 and underlying inflation would stay close to the baseline, because in the institute’s estimates oil reaches prices beyond energy mainly through the yen and wages. Rising goods and processed food prices are the main risk to that view.

Policy also supports demand less as it tightens. The policy rate less the inflation expected over two years stays below its neutral level until mid-2027, and the output gap narrows from about 0.5 percent to near zero by the end of 2028. The current account surplus reached 36.6 trillion yen in the twelve months to August and is likely to be about 33 trillion yen in 2026 as higher fuel prices reach import costs.

Chart

Policy stops supporting demand in mid-2027

Percentage points, IIF model

Real policy rate less real neutral, ppOutput gap, %

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Real policy rate and output gap

Date	Real policy rate less real neutral, pp	Output gap, %
24	−2.3	0.0
25	−1.5	0.5
26	−1.2	0.4
27	−0.4	0.3
28	0.2	0.1

Values at the start of each year, read from the chart; approximate.

Table

Growth slows as the BoJ edges past neutral

Annual averages unless stated; 2025 actual; IIF model baseline

IIF baseline forecasts for Japan, 2025 to 2027, with the 2027 consensus

	2025	2026	2027	2027 consensus
Real GDP, %	1.2	0.9	0.6	0.8
Core CPI, %	3.1	1.9	2.6	2.1*
Core CPI without tax cut, %	3.1	1.9	3.4	n.a.
Underlying inflation, %	3.0	2.2	2.9	n.a.
BoJ policy rate, end-year, %	0.75	1.50	2.00	1.82
USD/JPY, fourth quarter	154.2	157.5	154.9	150.5
Current account, % of GDP	4.8	4.8	4.7	4.6
Brent, $ per barrel	68	94	84	n.a.

Two tankers were hit in the Strait of Hormuz within 24 hours as October ended, and The National reported that investors were bracing for possible U.S. strikes on Iran after the Nov. 3 midterm elections.

“The yen and wages therefore decide whether the BoJ needs to go beyond 2%.”

IIF report, Nov. 2

The Bank of Japan next meets in December, the same month the government wants the tax cut enacted. Stopping at 1.75 percent, the institute says, would leave the yen weaker and underlying inflation higher for longer.

Sources

• Jonathan Fortun, “Japan’s Oil Shock and the Outlook for 2027,” IIF Asia Economic Views, Institute of International Finance, Nov. 2, 2026.
• Alvin R. Cabral, “Oil prices hit six-month high on Hormuz strikes and US threat to hit Iran,” The National (Abu Dhabi), Oct. 30, 2026.
• “Japan to release oil reserves as early as Monday (March 16): PM,” AFP, March 11, 2026, via The Star (Malaysia).
• Tom Westbrook, Satoshi Sugiyama and Rocky Swift, Reuters factbox on the history of Japan’s intervention in currency markets, Aug. 3, 2026 (syndicated copy).
• Takaya Yamaguchi, Yoshifumi Takemoto and Makiko Yamazaki, “Japan’s government approves Takaichi’s costly food tax cut despite fiscal concerns,” Reuters, Aug. 5, 2026 (syndicated copy).
• “Japan Govt Adopts Legislation on Consumption Tax Cut,” Jiji Press, Oct. 9, 2026, via Nippon.com.
• CNBC, Nov. 5, 2026.