Japanese business morale improved and corporate inflation expectations intensified during the first quarter, according to a closely followed survey, confirming the Bank of Japan (BoJ) in its intention to raise its interest rates this month.
However, businesses expect conditions to deteriorate further, with soaring fuel costs resulting from the war with Iran threatening to squeeze margins, the tankan survey reveals. These results highlight the risks weighing on a fragile economy, which complicates the BoJ’s rate decisions.
“Companies are clearly worried about the impact of the conflict. With energy costs soaring, they will have no choice but to raise prices,” said Mari Iwashita, chief rates strategist at Nomura Securities.
“Corporate inflation expectations are also rising. Overall, the tankan points to an accumulation of inflationary risks, which could increase the likelihood of a rate hike in April,” she added.
Sentiment among large manufacturing companies improved for the fourth consecutive quarter, with the benchmark index slightly exceeding market forecasts to settle at +17 in March, compared with +16 in December, marking its highest level since December 2021, according to the survey published Wednesday.
Robust demand for artificial intelligence chips and easing uncertainty surrounding US trade policy have offset pressure from rising production costs and conflict in the Middle East, a BoJ official said at a press briefing.
The index measuring the morale of large non-manufacturing companies held at +36, exceeding the median market forecast of +33, thanks to profit growth driven by price increases and international tourism.
“The Tankan survey shows that businesses are ignoring the energy shock caused by the war in Iran, which should encourage the BoJ to raise rates at this month’s meeting,” said Marcel Thieliant, head of the Asia-Pacific region at Capital Economics.
Large companies plan to increase their capital spending by 3.3% for fiscal 2026, compared to a 3.0% increase expected by consensus, according to the survey.
The survey was carried out between February 26 and March 31, with around 70% of companies responding before March 12, almost two weeks after the Israeli-American strikes against Iran on February 28.
A sign that they are preparing to suffer more of the repercussions of the conflict, manufacturing and non-manufacturing companies anticipate a deterioration in the economic situation over the next three months.
While the weak yen and slow wage growth have supported margins, profits and business morale will eventually erode due to weak exports and domestic demand, warned Stefan Angrick, head of Japan economics and border markets at Moody’s Analytics.
“The BoJ will welcome the strength of the Tankan, but without a more global economic base, it will be difficult to justify more aggressive rate increases,” he stressed.
INCREASED INFLATION EXPECTATIONS
Markets have been under pressure since the war with Iran effectively closed the Strait of Hormuz, a strategic crossing point for around a fifth of global oil and gas flows, which has propelled crude prices higher.
The conflict places the BoJ in a delicate position as it plans to raise still-low borrowing costs to cope with inflation that has exceeded its 2% target for almost four years.
Even though they decided to keep rates unchanged, BoJ officials discussed in March the worsening inflationary risks which, according to some, could justify regular or faster rate increases than expected.
A sign of this rise in expectations, companies forecast inflation at 2.6% in one year, compared to 2.4% in December. They also anticipate inflation of 2.5% over a three-year and five-year horizon, the highest projections ever recorded.
The results follow a BoJ report showing that Japan’s core inflation rate could come under greater upward pressure than in the past due to rising oil prices and a falling yen.
The BoJ ended a decade of massive stimulus program in 2024 and raised its rates, notably in December when it brought them to a 30-year high of 0.75%, estimating that Japan was progressing towards sustainably achieving its inflation target of 2%.
With a weak yen accentuating inflationary pressures, markets are now pricing in a probability of around 70% for a further rate hike in April.
