Japan's influential Council on Economic and Fiscal Policy (CEFP) has sent a clear message of caution to the Bank of Japan (BoJ).
The backdrop is challenging, to say the least. The ongoing conflict in Iran has pushed oil prices above $110 per barrel, and a persistently weak yen is making imports more expensive. Both factors are fueling inflation, which normally would pressure the BoJ to raise interest rates to cool the economy down.
However, the CEFP, which is chaired by the prime minister, is highlighting a major risk of doing so. Higher interest rates would significantly increase borrowing costs for Japan's small- and medium-sized enterprises (SMEs). These companies are the lifeblood of the nation's economy, accounting for approximately 99.7% of all firms and about 70% of total employment. Squeezing them with higher debt payments could stifle growth and even trigger a wave of corporate defaults.
This warning didn't come out of nowhere; it's the result of a clear sequence of events. First, the BoJ has already been on a path toward policy normalization, having raised its key interest rate to 0.75% in late 2025 and signaling that more hikes could follow, partly justified by three consecutive years of strong wage growth. Second, external shocks like the war, combined with the yen's slide past the critical 160 level against the dollar, have made the inflation fight more urgent. Yet, third, the negative side effects are already becoming apparent. Japanese government bond yields have hit multi-decade highs, and SME business sentiment has fallen to a three-year low, providing concrete evidence for the CEFP's concerns.
Ultimately, the CEFP's intervention serves as a crucial check on the BoJ's hawkish stance. It reframes the policy debate, forcing the central bank to weigh the risk of an economic slowdown more heavily against the risk of persistent inflation. As a result, the path forward for interest rates is now likely to be much slower and more cautious, unless inflation data shows a clear and broad re-acceleration driven by domestic demand.
- SMEs (Small- and Medium-sized Enterprises): Businesses below a certain size threshold. In Japan, they constitute the vast majority of companies and are a major source of employment.
- JGB (Japanese Government Bond): Debt securities issued by the Japanese government. The yield, or interest rate, on these bonds serves as a benchmark for borrowing costs across the economy.
- Stagflation: A difficult economic scenario characterized by slow economic growth (stagnation) combined with high inflation and typically high unemployment.