The Subsidy Mask Slips: Japan’s Inflation Problem Is Hiding in Plain Sight

1A 31-year high, and a board that was not unanimous

On 18 September the Bank of Japan lifted its benchmark overnight call rate from 1.00% to 1.25%, the highest level since April 1995. The new rate took effect on 24 September. The move was widely anticipated: Nikkei had reported a week earlier that the bank planned to act, citing rising crude oil prices and the depreciation of the yen.

The vote was less one-sided than the outcome. Seven of the nine board members backed the increase and two dissented, a split that tempered the signal about what comes next. According to press coverage, the policy statement said the bank expects consumer price inflation to exceed its 2% target in the second half of the fiscal year, and it named developments in West Asia, exchange rate movements and artificial intelligence related demand among the risks it will monitor. Governor Kazuo Ueda struck a balanced tone. Market commentary reported that further increases would depend on underlying inflation, wages and economic conditions, while easy financial conditions would be maintained to support growth.

The September decision

Bank of Japan Policy Board vote on 18 September 2026.

2The subsidy mask: why 1.9% understates the problem

Japan’s national inflation figures look benign, and they are partly an artefact of policy. Government subsidies for electricity, gas and gasoline, with gasoline support introduced from mid-March to cushion the oil price shock, have pushed energy prices down. In August, energy prices were 0.7% lower than a year earlier. Core inflation, which excludes fresh food, eased to 1.7%, the eighth consecutive month below the 2% target.

The underlying picture is firmer. Core-core inflation, which also strips out energy, held at 1.9%. In other words, remove the subsidies and the oil shock, and prices are rising at close to the bank’s target. The bank is acting on the trend and not on the headline.

Inflation in Japan: the gap between measures

Year-on-year change, selected measures. National data for August, Tokyo for August and September.

Tokyo sounds the alarm

The Tokyo data, which lead the national figures, delivered the warning. Core consumer prices in the capital rose 2.7% in September from a year earlier, against a consensus forecast of 2.3% and a reading of 1.8% in August, according to the Internal Affairs Ministry. Processed food rose 3.6%, and Teikoku Databank counted 4,965 price increases by major food and beverage makers in September, more than twice the number a year earlier. The Japan Times reported that more than 3,000 food and beverage products are due to rise in price from October.

Part of the jump is mechanical. Expanded childcare subsidies and a summer waiver of Tokyo water charges had temporarily held the index down, and both have now dropped out. Bloomberg described the result as inflation accelerating above the bank’s target as temporary government measures fade. That is the point at which the subsidy mask slips.

Tokyo core inflation: the upside surprise

Core CPI excluding fresh food, year-on-year.

An energy importer in a war economy

Japan imports almost all of its energy, which makes it among the most exposed of the large economies to the conflict in the Middle East. Higher oil prices lift costs for households and companies directly, and the subsidies that have absorbed part of the shock carry a fiscal cost that cannot be sustained indefinitely. Brent crude had eased to below US$105 a barrel by mid-September, relief by recent standards, but still high.

The authorities are watching the transmission. The Cabinet Office minister responsible for economic policy has said attention must continue to be paid to the effects of the Middle East situation. Jiji Press reported that private-sector forecasters expect higher crude oil costs to be passed on to consumers through retail prices in the July to September period, weighing on consumption. They also expect substantial wage increases to support household purchasing power: spring wage settlements exceeded 5% for the third consecutive year, and real wages have risen for seven consecutive months.

The weak yen compounds it

A second external force is working in the same direction. The yen traded at about 157 per dollar after the September decision and stood at 158.1 on 6 October, according to the European Central Bank’s reference rates. The gap in policy rates explains much of it: the Federal Reserve’s target range is now 3.75% to 4.00%, against 1.25% in Japan. Markets also read the yen’s slide after the decision as a bet that Japan’s tightening may lag the Fed’s pace.

A weaker yen raises the yen price of imported fuel, food and materials, so it adds to the very pressures the bank is trying to contain. The bank has named exchange rate moves as one of its risks.

The yen after the hike

Yen per US dollar. The 18 September point is approximate; later points are ECB reference rates.

Growth is holding, quietly

The economy is not overheating. Real GDP grew 0.4% in the April to June quarter, or 1.4% annualised, revised up from an initial 0.3% as business investment fell less than first estimated. Investment still declined 0.9%, private consumption was flat, and exports rose 0.4% while imports fell 1.7%. The S&P Global manufacturing PMI eased to 54.1 in September from 54.9 in August, the ninth consecutive month above the 50 expansion line, and the composite index slipped to 52.5. The survey linked elevated input costs partly to the Middle East war and the weaker yen. Unemployment was 2.4% in July.

This is the backdrop that makes the bank’s task delicate. Prices argue for gradual tightening and a modest economy argues for caution, which is why the governor’s tone was balanced and why the board was divided.

Three paths to the October meeting

The bank meets again on 29 and 30 October and will publish a new Outlook Report. The table sets out how the evidence could point in each direction. It is our analytical judgement, not a forecast.

Scenario	What it would look like	Likely stance
Patience	Tokyo strength proves partly one-off, oil keeps easing and wage data stay moderate. One market report said the summary of opinions from the September meeting signalled little urgency for another increase.	Hold at 1.25% and keep signalling a gradual path.
Pressure builds	Price increases broaden nationally as subsidies fade, the yen stays near 158 and oil re-accelerates. The bank’s own forecast already puts inflation above 2% in the second half of the fiscal year.	A further increase, in October or soon after.
Growth wobbles	Investment and consumption weaken, manufacturing slows further and the yen steadies as the rate gap narrows.	Pause, with the Outlook Report emphasising downside risks.

What to watch

Four indicators will shape the decision: the next national consumer price release, to see whether Tokyo’s acceleration is spreading; wage data; the path of oil; and the yen. On the political side, Reuters reported that Prime Minister Sanae Takaichi is due to promise a nimble response to unexpected market moves in a policy speech this week. Over all of them stands the 29 and 30 October meeting, which will show whether the bank regards 1.25% as the end of this phase or one step on the way to the neutral rate it is said to be approaching.