Japan’s second-quarter economic growth fell short of market expectations, complicating the Bank of Japan’s (BOJ) calculations around the timing of its next rate hike. Growth momentum has weakened, but inflation pressures have actually intensified—a set of conflicting signals emerging simultaneously.
Japan’s Cabinet Office announced on the 16th (local time) that real gross domestic product (GDP) grew at an annualized rate of 1.1% quarter-on-quarter in the second quarter of this year. That marks a sharp deceleration from the revised 1.9% recorded in the first quarter and also fell short of the market consensus of 2.0%. Still, Japan’s economy has now posted positive growth for three consecutive quarters.
Weak domestic demand lies at the heart of the slowdown. Uncertainty stemming from the Middle East conflict weighed on corporate investment sentiment, pushing capital spending down 1.2% quarter-on-quarter. The decline was steeper than the previous quarter’s -1.0% and stood in stark contrast to the 0.5% increase markets had anticipated. Private consumption also remained flat compared with the previous quarter. Markets had projected a 0.4% increase, but rising living costs—including energy prices—appear to have constrained household spending capacity.
Inflation indicators, however, remain hot. The second-quarter GDP deflator, released the same day, rose 2.6% year-on-year, topping the market forecast of 2.4%. Unlike the consumer price index (CPI), the GDP deflator is a broad inflation gauge that captures price movements across all goods and services produced domestically. The fact that this measure exceeded expectations suggests inflationary pressure is spreading beyond consumer goods into capital goods and government spending.
Corporate goods prices also remain elevated. In July, corporate goods prices rose 7.2% year-on-year. The combination of energy price increases tied to the Middle East conflict and yen weakness has kept cost burdens on businesses persistently high.
With growth figures coming in weaker than expected, some analysts argue the BOJ’s case for raising rates has been somewhat diminished. Given that both consumption and capital spending are simultaneously sluggish, the BOJ is now more likely to cite yen-driven inflation pressure—rather than solid economic momentum—as its primary justification if it moves to hike rates next month.
Even so, markets continue to lean toward a September rate hike. The probability of a BOJ rate increase at its September 18 meeting, as reflected in overnight swap markets, stands at approximately 80%. Yen weakness is another factor increasing the need for tightening. Although the United States and Japan jointly intervened in currency markets last month, the yen has since retreated back to around 159 per dollar (approximately $0.9997), surrendering much of the gains achieved at the time.
Bloomberg Economics noted that “while second-quarter GDP exceeded potential growth, the details weaken the case for a BOJ rate hike in September,” adding that the decline in capital spending could signal that corporate outlooks are becoming more cautious.
Naoki Hattori, senior economist at Mizuho Research & Technologies, said, “A September rate hike remains our base-case scenario even after these results,” adding that “the external environment pressuring the BOJ to raise rates has also taken shape following the July U.S.-Japan joint currency intervention.”
The BOJ ended its negative interest rate policy in March 2024 and raised its short-term rate target to 0.5% in July 2025—the highest level since 2008. BOJ Governor Kazuo Ueda has consistently emphasized that sustained wage growth is necessary for further policy normalization. With major labor unions demanding wage increases of roughly 5% in the 2026 shuntō (spring wage negotiations), some observers suggest that if wage growth catches up with inflation, the BOJ would have a stronger rationale to continue raising rates.
Japan’s economy has moved beyond the deflation that persisted for decades, with the GDP deflator turning positive in 2022 and maintaining an upward trajectory since. While this signals economic recovery, it also heightens the burden on the BOJ to balance growth support against the risk of an inflation overshoot. In the coming months, the BOJ’s policy path, the yen exchange rate, and the global interest rate environment are expected to be the key variables determining the direction of Japan’s economy.