Tokyo — Business sentiment among Japanese firms improved in the three months to March while corporate inflation expectations rose to record levels, a closely watched survey showed on Wednesday, strengthening the case for a near-term interest rate hike by the Bank of Japan, even as escalating fuel costs linked to the Iran conflict darken the economic outlook.

The central bank’s quarterly “tankan” survey indicated that large manufacturers’ sentiment index rose to +17 in March, slightly above market forecasts of +16 and up from +16 in December, marking its highest level since December 2021.

The improvement extended a fourth consecutive quarter of gains, suggesting that parts of Japan’s industrial sector have continued to recover despite mounting global uncertainties.

Sentiment among large non-manufacturers remained robust, with the index holding steady at +36, surpassing a median market forecast of +33. The strength in the services sector was supported by rising profits from price increases and a continued recovery in inbound tourism, according to the survey data.

A Bank of Japan official said resilient demand for artificial intelligence-related semiconductors and easing uncertainty over U.S. trade policy helped offset pressures from higher input costs and geopolitical tensions in the Middle East.

At the same time, the survey highlighted growing inflationary pressures within the corporate sector. Companies reported rising expectations for future price increases, reflecting the impact of higher fuel and raw material costs.

Analysts said this trend could provide additional justification for the central bank to move toward policy normalisation after years of ultra-loose monetary settings.Mari Iwashita, executive rates strategist at Nomura Securities, said the survey underscored mounting inflation risks driven by external shocks.

She noted that companies facing surging energy costs may increasingly pass those expenses on to consumers, reinforcing upward pressure on prices.The data comes at a critical juncture for the Bank of Japan, which is weighing whether to raise interest rates as early as this month.

Market participants have been closely monitoring the tankan survey as a key gauge of corporate sentiment and investment plans.Despite the relatively upbeat current conditions, the survey revealed growing caution among firms about the near-term outlook.

Both manufacturers and non-manufacturers expect business conditions to deteriorate over the next three months, reflecting concerns about the economic fallout from the Iran conflict and its impact on energy markets.

The ongoing conflict has driven up global fuel costs, increasing operational expenses for Japanese companies that rely heavily on imported energy. The resulting squeeze on margins is expected to weigh on profitability, particularly for industries with limited pricing power.

Marcel Thieliant, head of Asia-Pacific at Capital Economics, said the strength of the survey could still encourage policymakers to act. He noted that firms appeared to be absorbing the energy shock for now, suggesting that underlying economic conditions remain stable enough to support a rate hike in the near term.

Capital expenditure plans among large firms also pointed to cautious optimism. Companies expect to increase investment by 3.3% in the fiscal year 2026, exceeding a median market forecast of a 3.0% rise.

The planned increase suggests that firms are continuing to invest in growth despite heightened uncertainty.The survey period, which ran from February 26 to March 31, captured responses from roughly 70% of firms by March 12, shortly after the escalation of hostilities involving the U.S.-Israel attacks on Iran on February 28.

This timing indicates that early assessments of the conflict’s economic impact are already being reflected in corporate sentiment.Economists cautioned that the positive momentum seen in the survey may not be sustained if external conditions worsen.

Stefan Angrick said that while a weak yen and subdued wage growth have supported corporate margins, broader economic challenges remain.He noted that export growth could weaken amid slowing global demand, while domestic consumption may remain constrained by modest income gains.

Over time, these factors could weigh on corporate profits and sentiment, complicating the central bank’s policy decisions.The survey underscores the delicate balance facing policymakers as they navigate between emerging inflationary pressures and risks to economic growth.

While improving sentiment and rising prices strengthen the case for tightening monetary policy, the uncertain global environment, particularly developments in the Middle East, continues to pose significant challenges for Japan’s export-driven economy.

The HSBC flash India Composite Purchasing Managers’ Index, compiled by S&P Global, fell to 56.5 from February’s 58.9, missing expectations in a Reuters poll and marking the sharpest slowdown in 18 months. While readings above 50 indicate expansion, the drop signalled a loss of momentum at the end of the fiscal year.

Manufacturing slowdown deepensThe manufacturing sector bore the brunt of the slowdown, with its PMI declining to a 4-1/2-year low of 53.8 from 56.9. Factory output growth weakened to its softest pace since August 2021, reflecting heightened uncertainty and subdued consumer demand.

The services sector, which makes up the bulk of India’s economy, also eased, with its PMI slipping to 57.2 from 58.1.Cost pressures intensifyInput costs rose at their fastest pace since June 2022, driven by higher prices for oil, energy, food, metals and chemicals.

Firms responded by increasing selling prices at the quickest rate in seven months, though some absorbed costs by compressing margins.India’s heavy reliance on imported energy has amplified the impact.

As the world’s third-largest oil importer, it sources about 90% of its crude and nearly half of its natural gas from overseas, making it vulnerable to price shocks linked to disruptions in the Strait of Hormuz. Oil prices have risen more than 40% since the conflict began.

External demand offers supportDespite weakening domestic demand, international orders rose to their highest level since the sub-index was introduced in 2014, with businesses reporting increased demand from Asia, Europe, the Americas and the Middle East.

Business confidence improved to its strongest level since September 2023, supporting the fastest pace of job creation since August, even as inflation risks mount and growth prospects face renewed pressure.