Japan's economy expanded for a third consecutive quarter in the second quarter of 2026, but the pace of growth was markedly slower than anticipated, raising fresh questions about the Bank of Japan's (BOJ) ability to proceed with further interest rate hikes.

Preliminary data released by the Cabinet Office on Monday showed that real GDP rose 0.3% quarter-on-quarter in the April-June period, translating to an annualized rate of 1.1%. Both figures fell short of market expectations, which had projected a 0.5% quarterly increase and a 2.0% annualized gain. The softer performance was driven by tepid private consumption and a further decline in capital expenditure, highlighting ongoing weakness in domestic demand, which was partially offset by a positive contribution from net exports.

A detailed breakdown of the preliminary estimates reveals a mixed picture. Private consumption, which accounts for more than half of the economy, was essentially flat, showing a marginal decline of 0.02%. This was a significant miss compared to the anticipated 0.4% to 0.5% growth, as persistent inflation and elevated energy costs continued to weigh on household spending. Capital expenditure, specifically private non-residential investment, contracted by 1.2% quarter-on-quarter, a steeper drop than in the previous period and far below expectations for growth. Business investment sentiment has been hampered by uncertainty stemming from the Middle East conflict. In contrast, net exports contributed approximately 0.5 percentage points to GDP growth, with exports rising 0.5% and imports falling 1.5%. The decline in imports was partly attributed to reduced crude oil purchases following shipping disruptions related to the Strait of Hormuz. Overall, domestic demand acted as a 0.2 percentage point drag on growth, making external demand the primary pillar of support.

The second quarter marked the first full period in which the Japanese economy felt the full impact of the Middle East conflict. Surging energy prices have squeezed corporate profits and household real incomes, while supply chain disruptions have fostered a more cautious outlook among businesses. The weakness in private consumption, while partly influenced by one-off factors such as the shifting of government subsidy-related spending, largely reflects the core constraint of cost-push pressures. The consecutive decline in capital expenditure underscores companies' decisions to delay expansion plans amid geopolitical risks. While exports of automobiles and semiconductors have shown resilience, they have been insufficient to fully offset the drag from soft domestic demand.

In the wake of the GDP data, market participants have intensified their debate over the timing of the BOJ's next policy move. The soft domestic demand figures may prompt the central bank to adopt a more cautious tone in its communications. However, a majority of analysts still consider a rate hike in September to be a strong possibility. Overnight index swaps had previously priced in roughly an 80% probability of a September move, driven by factors including the weak yen, sticky inflation, and imported price pressures from the Middle East conflict. The Japanese yen's reaction to the data was relatively muted, trading around the 159 level against the US dollar, with its support coming more from expectations of a slower pace of rate hikes by the Federal Reserve than from the domestic economic figures.

The latest GDP report confirms that the Japanese economy is navigating a challenging period of weak domestic demand alongside external shocks. For the BOJ, this growth slowdown complicates the task of communicating its policy trajectory, though it does not necessarily derail the path toward further normalization, particularly given that energy prices and the yen's value continue to pose upside risks to inflation. Investors are now advised to monitor upcoming wage and price data, corporate capital expenditure plans, and the ongoing impact of the Middle East situation on import costs. If consumer spending and business investment remain sluggish, growth in the third quarter could decelerate further. However, if external demand and policy support can stabilize the situation, the economy could still maintain a modest pace of expansion.