The surge in oil prices combined with a sagging yen raises the risk that Japan will slide into stagflation, prompting the government to ramp up fiscal spending while complicating the central bank’s mission to normalize its policy settings.

Oil topped $100 per barrel Monday amid escalating hostilities in the Middle East and widening stress on oil shipping operations and the global energy infrastructure. The yen weakened against the dollar, moving closer to a key threshold of 160 per dollar, a level where authorities intervened to support Japan’s currency in 2024. Stocks also tumbled while long-term bond yields rose.

Japan imports most of its energy needs, making its economy and inflation figures highly vulnerable to moves in crude prices. In the current predicament the surge in oil costs comes on top of weakness in the yen, with both revving up price pressures.

“This is a double punch for Japan,” said Yuichi Kodama, chief economist at Meiji Yasuda Research Institute. “A spike in oil on top of a weak yen would weigh heavily on Japan’s economy. The risk of stagflation is rising without a doubt.”

Kodama stressed that it all depends on how long oil prices stay elevated. If the surge is prolonged, Prime Minister Sanae Takaichi would surely need to consider a fresh economic package, he said. A further increase in spending might then re-ignite concerns among investors about the longer-term finances of the nation, fears that sparked a sharp selloff in the bond market in January.

Takaichi said Monday that she is already considering tapping reserve funds in an extra budget for the current fiscal year and in a regular budget for the year starting in April to put a lid on gasoline prices.

“We are considering measures to prevent gasoline prices, which are essential for many people, from exceeding an acceptable level,” Takaichi said. “We are not considering additional budgetary measures. We are simply examining how to utilize the funds currently available.”

Those comments came amid reports that Group of Seven finance ministers will discuss a possible joint release of oil from reserves on Monday, according to people familiar with the matter.

The reports pared gains in oil prices. Brent was 15% higher at around $106 a barrel, but much lower than the session peak of $119.50. The yen weakened to around 158.90 per dollar as risk off market sentiment boosted demand for the greenback.

If oil returned to $120 and stayed there, it would shave 0.47 percentage point off annual economic growth and boost inflation by 0.83 percentage point, said Takahide Kiuchi, executive economist at the Nomura Research Institute.

“Even if the G-7 jointly releases oil reserves, it is unlikely to have a sustained effect in suppressing crude oil price increases amid the ongoing deterioration of the Iran situation,” Kiuchi said.

Japan hasn’t experienced stagflation, a combination of low growth, high inflation and rising unemployment, for years as it struggled with low growth and falling prices.

Like many major economies, the Asian nation experienced stagflation in the 1970s in the aftermath of the first oil shock. Inflation reached close to 25% and the economy shrank in two quarters in 1974, with the first of those contractions the biggest at that time for comparable data back to 1955.

Japan’s current reliance on oil from the Middle East is hovering around 90%, hitting 95.1% in January, according to Japan’s Trade Ministry. Much of that oil makes its way to Japan through the Strait of Hormuz.

The surge in oil prices comes ahead of data Tuesday that are expected to confirm that private consumption barely advanced in the fourth quarter as households remain cautious on discretionary spending in an already elevated inflation environment.

Those concerns over Japan’s cost of living crunch are continuing to simmer. Takaichi led her party to a landslide victory in an election last month, partly supported by hopes that her expansionary fiscal policies would support households after inflation stayed above the Bank of Japan’s target for four straight years. But if the inflation problem appears poised to deepen, she may take a more fiscally aggressive tack.

What Bloomberg Economics Says…

“We now expect the BOJ to hike rates in April and see a chance of a March move, earlier than our previous baseline of July.”

— Taro Kimura, economist

For the full report, click here.

If oil prices continue to soar, economists are split on whether the central bank would take action earlier to raise rates and tackle inflation or wait out its next move until it is more confident that the economy will be strong enough to cope with higher borrowing costs.

While Taro Kimura at Bloomberg Economics expects the BOJ to move earlier than previously expected, others, including Kodama, expect the current economic and market environment to encourage the BOJ to refrain from raising its benchmark interest rate for the time being. Officials will first need to gauge the potentially heavy impact from the Iran conflict, Kodama said.

“The BOJ is in a very tough spot,” Kodama said. “They want to raise rates in a favorable economic environment, while this Middle East situation could drag on the economy considerably.”

Written by: Toru Fujioka and Yoshiaki Nohara — With assistance from Takashi Hirokawa​​ @Bloomberg

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