In the first G5 central bank announcement of the week, overnight the Bank of Japan held its benchmark interest rate in a 6-3 vote, despite forecasting a sharp rise in inflation as the war in the Middle East sends commodity prices higher and clouds the global economic outlook while testing Japan's given its exposure to rising energy prices.

While the decision on Tuesday to keep rates at about 0.75% was in line with market expectations, it came via a rare six-to-three vote split of the Monetary Policy Committee, the biggest divergence of opinion under governor Kazuo Ueda, and since the launch of the bank’s negative interest rate policy in 2016.

The three dissenters called for an immediate rate increase to 1%, reflecting fears that the BoJ is at risk of falling even further behind the curve by postponing rate increases as it seeks to “normalise” monetary policy at a time when Japan's inflation is dangerously overheating due to sharp wage increases in recent years. 

After the BOJ announcement, traders were convinced that rates will rise after the next meeting in June.

Speaking at a press conference later on Tuesday that was widely interpreted as hawkish, Ueda said the central bank would make appropriate decisions “so that we do not fall behind the curve”, yet even now he refused to outline a formal timeframe for the BoJ to decide whether conditions were right to raise rates.

“Given the high level of uncertainty around the conflict in the Middle East, the likelihood of achieving our forecasts has declined,” said Ueda. 

He added that the central bank “wants to spend a little more time scrutinizing how the Middle East conflict affects the economy and prices, and whether the risk to growth and inflation could change”.

While two of the three dissenters, Naoki Tamura and Hajime Takata, are known hawks who have voted against the governor at previous meetings, analysts noted the addition of the more dovish Junko Nakagawa.

“Three dissenting votes is not a huge surprise, but Nakagawa being one of them is,” said JPMorgan senior Japan economist Benjamin Shatil. “The Board is sending a clear signal that it is ready for a June rate hike. Whether global conditions have settled sufficiently and tacit government approval is in place by then is another question.”

In the BoJ’s stagflationary outlook statement, the bank warned that Japan’s economic growth was likely to slow in the current fiscal year; at the same time it also significantly raised its inflation forecast over the same period.

The committee said core CPI was expected to reach 2.8% for the current fiscal year ending in March 2027, up sharply from its previous forecast of 1.9% issued just three months ago. 

“The rise in crude oil prices reflecting the impact of the situation in the Middle East is expected to push down corporate profits and households’ real income,” the BoJ said.

The statement added that the risks to economic activity were “skewed to the downside and risks to prices are skewed to the upside”. In other words, a classical staglationary setup. 

Japan is particularly vulnerable to energy shocks from the crisis in the Gulf. The country is heavily reliant on imported energy, and sources more than 90% of its crude from the Middle East.

The BoJ was the first of five major central banks making rate decisions this week, with the Fed, the European Central Bank, the Bank of England and Bank of Canada all expected to follow its lead and keep rates on hold as they asses the war-related risk of prolonged inflation.

Marcel Thieliant, head of Asia-Pacific at Capital Economics, underlined the BoJ’s upward revision of inflation forecasts, including that inflation will average 2.2% in fiscal 2028.

“Barring a renewed escalation in the Middle East, the bank will probably lift its policy rate again at its next meeting in June,” he wrote in a note to clients.

Goldman's Akira Otani said that July is still his base-case scenario for the next rate hike. "However, uncertainty over the timing of the rate hike is high. While it could come earlier than July depending on inflationary pressures, we would expect it to be pushed back from July to H2 if the Japanese economy were to fall into a recession through factors like a deterioration in the terms of trade."

"Even if tensions in the Middle East were to stabilize, we believe a July rate hike is more likely than a June one. Uncertainty over crude oil production and transportation in the Middle East will remain high for the time being and the impact remains uncertain even in a de-escalation scenario. Under such circumstances, and with no signs of groundwork being laid with the government for a rate hike, data and information showing the Japanese economy is unlikely to suffer a significant negative impact and is likely to achieve moderate growth will become more important, in our view. Therefore, while the possibility of a June rate hike cannot be ruled out, we see no need to change our base-case scenario of a July rate hike."

The BoJ’s hawkish statement pushed the yen higher against the US dollar, before the Japanese currency weakened back to around ¥159.62, and was lower on the day. The widely watched Nikkei 225 Average, which surged to an all-time high of 60,537 points on Monday, shed 1%, while the Topix, which has a heavier weighting of banks and financial companies, was up 1%.