Japan’s 2.4% underlying inflation puts a higher BoJ terminal rate in play

The debate is shifting from when the BoJ hikes again to where rates peak, which matters most for the front end of the JGB curve. A market that moves from pricing a terminal rate around 1.75% to one closer to or above 2% would be likely to push two-year and five-year yields higher after their recent rally. The yen firmed after the data, but a sustained rally would probably need the BoJ to endorse a higher peak next week, given the large trade deficit and the wide gap with US rates. For equities, a higher-for-longer BoJ path tends to favour banks over exporters. Oil remains the key upstream driver: Middle East-linked energy costs are feeding Japanese inflation even with fuel subsidies in place, so crude above $110 a barrel keeps upside risk on both prices and the BoJ’s forecasts.---Earlier:Japan core inflation tops BoJ’s 2% target for first time since December, yen firms--- Japan’s inflation is now broad enough that a December BoJ hike looks like the starting point rather than the question, with markets turning to how far the bank will ultimately need to go.Summary:Japan’s core CPI rose 2.1% in September from 1.7%, above the BoJ’s target for the first time in nine months. The measure excluding fresh food and fuel rose 2.4% from 1.9%.Goods inflation rose to 2.8% from 2.6%, and services inflation rose to 1.5% from 1.2%, a sign that firms are passing on higher labour costs.Higher fuel costs from the Middle East conflict, a weak yen and AI-driven demand are offsetting the effect of government fuel subsidies.The BoJ is expected to hold rates at 1.25% next week but may raise its inflation forecasts and say underlying inflation has likely reached 2%.Many analysts expect a hike to 1.50% in December, with a terminal rate around 1.75% to 2%, and some see the risk of a higher peak.The PMI showed hiring slowing to a 14-month low, and the economy minister said conditions are not yet met to declare deflation over. Japan’s underlying inflation accelerated in September, with price increases broadening across goods and services despite government fuel subsidies. The data strengthen expectations of a Bank of Japan rate hike in December and are shifting attention to how high rates may ultimately go.Core consumer prices, which exclude fresh food but include fuel, rose 2.1% from a year earlier, matching forecasts and accelerating from 1.7% in August. It was the first reading above the BoJ’s 2% target in nine months, Reuters reported. The index excluding both fresh food and fuel, which the BoJ watches closely as a better measure of demand-driven inflation, rose 2.4% from 1.9%.The breakdown showed price pressure spreading. Goods inflation rose to 2.8% from 2.6%, while services inflation increased to 1.5% from 1.2%, suggesting firms are starting to pass higher wages on to customers. Rising fuel costs linked to the prolonged Middle East conflict, higher import prices from a weak yen and strong demand linked to artificial intelligence have together blunted the impact of the fuel subsidies.Services inflation remains the weak link in that picture. At 1.5%, it is still well short of 2%, a reminder that the wage-driven, domestically generated inflation the BoJ has long sought is building only gradually.The BoJ is widely expected to keep its policy rate at 1.25% at its two-day meeting ending October 30, having raised it to a 31-year high in September. Sources have told Reuters the bank may revise up its inflation forecasts, signal that underlying inflation has likely reached 2%, and stress its focus on anchoring inflation at that level. Governor Kazuo Ueda said last week that the BoJ would not tolerate an inflation overshoot.One economist told Reuters that rising energy costs and their knock-on effects should push core inflation higher, but that prices are not accelerating sharply enough to justify back-to-back hikes, and he expects the next move in December. Many analysts polled by Reuters expect the BoJ to raise rates to 1.50% in December, with a terminal rate of around 1.75% to 2%. Some see the risks tilting higher. Capital Economics said there is little evidence that tightening so far has slowed the economy and that the policy rate may peak above its 2% forecast. Recent surveys have shown little sign that higher rates are weighing on loan demand.Not all of Friday’s data supported a more aggressive path. A flash business survey released the same morning showed private sector growth steady but subdued in October, with job creation slowing to a 14-month low and services firms cutting staff for the first time in more than a year. Economy Minister Minoru Kiuchi said conditions have not yet been met for the government to declare an official end to deflation, and he urged the BoJ to guide policy appropriately.That leaves the BoJ facing a familiar balance at next week’s meeting: inflation that is finally broadening, against signs that the labour market and domestic demand are losing some momentum. How the bank describes that balance in its outlook report is likely to shape market expectations for the policy rate well beyond December.  This article was written by Eamonn Sheridan at investinglive.com.