What Japan signals about the war-hit economy
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Illustration: Lindsey Bailey/Axios
The Iran war is trapping the world's central banks with an energy shock that simultaneously undermines growth and stokes inflation, with no good policy response to either.
- Each of the world's most important central banks faces that dilemma in policy meetings this week.
Why it matters: From Tokyo to Washington, central banks that were on track to normalize policy are now paralyzed, unsure whether the energy price shock will prove more consequential in causing sustained inflation or in sapping growth.
- The longer the war drags on, the more the global economy will have to grapple with a stagflationary problem that no interest rate decision can solve.
- The Bank of Japan was the first to deal with this dilemma on Tuesday, as it elected to leave rates steady. The Fed follows on Wednesday, and the European Central Bank and Bank of England each meet on Thursday.
What they're saying: Like the BOJ, other central banks this week will "hold rates steady as they all face slightly different versions of the same dilemma," Karl Schamotta, chief market strategist at global payments firm Corpay, wrote in a note Tuesday morning.
- Namely, "whether the energy shock rippling through global markets will prove transitory or become embedded in prices, echoing the post-pandemic inflation surge."
Driving the news: The BOJ held its benchmark rate steady at 0.75% on Tuesday. Before the war, central bank watchers had expected a rate increase — a continuation of the gradual tightening cycle that the BOJ began in March 2024, when it raised rates for the first time in 17 years as it escaped decades of deflation and negative borrowing costs.
- Three of nine board members dissented in favor of an immediate hike — a sign that some top officials believe that the inflation threat feels urgent enough that waiting carries its own risks.
- The bank slashed its 2026 growth forecast in half, to 0.5%, while raising its core inflation outlook 0.9 percentage point, to 2.8% — the arithmetic of a stagflation trap.
Zoom in: Japan is particularly exposed to Iran war fallout: It sources more than 90% of its crude oil from the Middle East, nearly all of it through the Strait of Hormuz, which remains effectively closed.
The big picture: In the context of several reoccurring shocks over the past six years, central banks are questioning whether war-related effects will scramble the usual playbooks.
- Japan could raise rates because energy costs and a weakening yen are forcing the bank's hand, not because the economy is chugging along and can digest higher borrowing costs.
"Our decision today is based on the view that central banks should look through temporary supply shock-driven inflation," BOJ governor Kazuo Ueda said Tuesday at a press conference.
- "But if such shock brings about second-round effects on underlying inflation, we must raise interest rates," Ueda added.
- The central bank chief faces a complication familiar to his global counterparts: political pressure to hold off on hiking rates as Japanese Prime Minister Sanae Takaichi — an advocate of looser monetary policy — weighs fuel subsidies and other measures to cushion households from rising energy costs.
The bottom line: The BOJ expects to avoid a 1970s-style oil shock, but Ueda acknowledged an uncomfortable parallel: Rates are still below neutral, meaning the bank is already behind the curve if inflation takes hold.
