Japan¡¯s factory output fell in March as the war in Iran clouded prospects for global demand while also threatening manufacturers¡¯ margins by way of higher energy costs.

Industrial production dropped 0.5% from February, the industry ministry reported Thursday. Economists had expected a 1.1% increase. Output gained 2.3% from a year earlier, compared with expectations of a 2.2% gain.

Thursday¡¯s report reflects a period in flux, with business prospects for manufacturers starting to dim as the impact of the Middle East conflict rippled through the global economy.?

Earlier this month, the International Monetary Fund said the global outlook ¡°has abruptly darkened following the outbreak of war in the Middle East.¡± The IMF trimmed its 2026 global growth forecast to 3.1%.

Output of general-purpose and industrial machinery fell, along with production in the petroleum and coal products industry. It was the second straight month in which overall output declined, although the quarterly figure registered an increase after a strong result in January.

¡°In the first quarter, production managed to rise slightly, but obviously the Middle East situation weighed on parts of the March figures,¡± said Taro Saito, head of economic research at NLI Research Institute. ¡°While the outlook is currently quite optimistic, I believe there is a significant risk of a downside deviation.¡±

The ministry said manufacturers expect output to gain in April and May.

Saito said the contrasting dynamics of surging demand for semiconductors related to artificial intelligence and an increasingly difficult environment for industries relying on oil could keep the figures fluctuating over the near term.

¡°I think AI-related sectors will continue to provide support, and I expect this to be a tug-of-war with the decline in production of oil-related commodities,¡± he said.

Prime Minister Sanae Takaichi¡¯s government has said it can secure crude oil for this year by tapping reserves and developing alternative routes to the Strait of Hormuz. But the government also said bottlenecks remain in the supply of petroleum products.

¡°The weaker-than-expected data also point to downside risks to growth. That leaves the BOJ walking a tightrope on the timing of its next rate hike, especially amid pressure from pro-stimulus Sanae Takaichi¡¯s administration to keep rates low,¡± Bloomberg economist Taro Kimura said, referring to Japan¡¯s central bank.

Separately, retail sales increased 1.3% in March from February and advanced 1.7% from a year earlier, rebounding after declines in the previous month. Consumption trends remain fragile amid persistent inflation. Japan¡¯s key inflation gauge accelerated in March for the first time in five months.

The Bank of Japan left its key interest rate unchanged at 0.75% on Tuesday in a split vote that boosted the chance of a June hike. In its latest outlook report, it said...