BOJ Faces Dilemma as Japan's Q2 GDP Growth Slows and Inflation Pressures Intensify

Japan's economy grew at an annualized rate of 1.1% quarter-on-quarter in the second quarter, falling short of market expectations and weakening growth momentum. The real gross domestic product (GDP) figure marks a sharp deceleration from the revised 1.9% recorded in the first quarter, but still indicates positive growth for three consecutive quarters.

The slowdown is largely attributed to weak domestic demand, with corporate investment sentiment weighed down by uncertainty stemming from the Middle East conflict. Capital spending declined 1.2% quarter-on-quarter, steeper than the previous quarter's -1.0%, and private consumption remained flat compared to the previous quarter.

However, inflation indicators remain hot, with the GDP deflator rising 2.6% year-on-year, exceeding market forecasts of 2.4%. Corporate goods prices also continue to rise, increasing 7.2% year-on-year in July due to energy price increases tied to the Middle East conflict and yen weakness.

The Bank of Japan (BOJ) is now more likely to cite yen-driven inflation pressure as its primary justification for a potential rate hike next month, rather than solid economic momentum. Despite this, markets continue to lean towards a September rate hike, with an 80% probability reflected in overnight swap markets.