Tokyo's consumer price inflation eased more than expected in December, providing relief as pressure from food and energy costs diminished compared to previous months. The Japanese capital saw its consumer prices excluding fresh food rise 2.3% in December from a year earlier, according to the Ministry of Internal Affairs and Communications.

Inflation Data Shows Significant Cooling

The December inflation reading represents a sharp deceleration from the previous month's 2.8% rate, marking the first time since August that Tokyo has experienced a slowdown in these key figures. The decline exceeded economist expectations, who had forecast the reading to slow to 2.5%.

Food and Energy Drive Decline

The inflation slowdown was largely driven by softer food price gains and falls in energy costs. A deeper measure that excludes energy fell to 2.6%, while the total inflation gauge decreased to 2.0% from 2.7% in the prior period. Tokyo's statistics serve as a leading predictor of inflation patterns across Japan, with the Tokyo Metropolitan Region having an estimated population of around 40 million.

Bank of Japan Maintains Hawkish Stance

Despite the cooling inflation data, the development is unlikely to deter the Bank of Japan from further rate hikes. The Japanese central bank recently voted unanimously to lift the policy rate to 0.75%, continuing its trend of raising interest rates while other major economies cut benchmark rates. This recent hike has taken the benchmark rate to the highest level since 1995.

Bank of Japan Governor Kazuo Ueda hinted at further monetary tightening during the rate announcement, noting that despite cooling inflation, the consumer price index for the capital city remains above the central bank's target of 2%.

Market Response

Japanese equity markets responded positively to the inflation news, with the Nikkei 225 index trading with gains of 0.94% or 475.86 points, reaching 50,883.65 at the time of reporting. The positive market reaction suggests investors view the inflation moderation as a balanced development that maintains economic stability while supporting the central bank's policy framework.

Japan's financial markets are closely watching Thursday's two-year government bond auction as investors assess the Bank of Japan's monetary policy direction following last week's significant rate adjustment. The central bank raised its policy rate to a three-decade high, prompting widespread market speculation about future rate increases aimed at controlling inflation and supporting the yen.

Market Performance and Yield Movements

Bond yields showed mixed movements in morning Tokyo trading, with the two-year tenor declining 1.50 basis points to 1.09%. The broader yield curve reflected investor uncertainty, as shown in the following market data:

The two-year rate, which demonstrates higher sensitivity to monetary policy expectations, reached its highest level since 1996 earlier this week. Additionally, the 10-year breakeven inflation rate jumped to its highest level in data extending back to 2004, indicating elevated market expectations for future price pressures.

Central Bank Policy Concerns

Governor Kazuo Ueda's recent comments provided limited guidance on the Bank of Japan's future rate trajectory, contributing to yen weakness and higher yields. Market analysts express concerns about the central bank's policy positioning.

"Inflation expectations and forecasts for the neutral rate are rising due to concerns that the BOJ is behind the curve," said Katsutoshi Inadome, senior strategist at Sumitomo Mitsui Trust Asset Management Co. "There's some unease about the auction."

Overnight index swaps indicate market expectations for another rate hike by September of next year, though the yen's depreciation and rising yields have moderated since the week's beginning following Japanese authorities' verbal currency interventions.

Auction Expectations and Fiscal Concerns

The upcoming auction represents the final two-year debt sale for this year and is expected to be the first with a yield above 1.00%. Investors are monitoring several key metrics:

Market participants also face uncertainty regarding the government's bond issuance plans for fiscal 2026. Fresh bond issuance for the budget covering the year from April will remain under ¥30.00 trillion but will exceed the current year's initial ¥28.60 trillion issuance.

"It's not a good time to buy," said Miki Den, senior rates strategist at SMBC Nikko Securities. "There's a high likelihood that two-year bonds will see increased issuance, so there's a risk of incurring unrealized losses immediately after purchases."

Japan's primary dealers have indicated that increased issuance of two-, five- and 10-year government bonds would be desirable for the next fiscal year, while recommending reduced sales of super-long debt. The fiscal 2026 budget is expected to receive Cabinet approval on Friday, adding another layer of market focus to this week's developments.