Japan: 2% inflation at last?

The hoped-for attainment of a robust, long-lasting 2% inflation rate - the objective of policy since January 2013 - is still in question.

To be sure, the headline (all items) inflation rate is above 2% and has been for three years. But underlying measures of inflation, inflation expectations, money growth and real growth prospects all indicate that low inflation has not yet been permanently conquered.

Bank of Japan Governor Ueda commented at the ECB Sintra Forum in July 2025 about the three main elements of the inflation trend.

First, underlying inflation as determined by wage-price dynamics. There is a wage-price spiral, at the moment, amplified by resilient domestic demand. Underlying inflation is rising but is somewhat below 2% (see chart).

Second, the effect of tariffs which is expected to be negative: it is a broadly deflationary influence.

Third, domestic supply shocks driven by increases in food prices. Food prices account for about 50% of headline inflation. Components 1 and 2 will produce a slow increase in underlying inflation to around 2% by end 2026/start of 2027 in Ueda’s view. The third component will subside towards the end of 2025.

Prospect for the policy interest rate depend on these three dynamics.

Ten-year inflation expectations remain around 1.5% (see chart). Commenting at the October 2024 IMF meetings, Governor Ueda said “When inflation expectations are so low, it takes a long time to change them.” With huge uncertainty he wanted to proceed “cautiously and gradually”. That is exactly what has happened. 

Governor Ueda sees the natural real rate of interest “somewhere between -1% and +0.5% but thinks that each of these estimates comes with a big confidence interval.” If 2% inflation cannot be achieved on a reliable basis – maybe 1.5% is more realistic – that points to nominal interest rates ending up at between 0.5% and 2.0%.

One recent development, however, impacts the assessment of interest rate trends. Bond yields, having been subdued for a long time have risen sharply.

The policy agenda of the new prime minister, Sanae Takaichi; a global trend to higher government borrowing costs; and Japan's persistently large government debt level are the main factors behind that.

Sanae Takaichi became Japan's first female Prime Minister (and President of the LDP) in October 2025. She is a long-time advocate of "Abenomics," the economic policies of Shinzo Abe. "Sanaenomics," is a remodelled version of Shinzo Abe's "three arrows". It has three pillars - rather than arrows:

Easy monetary policy: Sanae is of the view that the Bank of Japan should not be raising interest rates.

Fiscal Spending: Sanae emphasises aggressive government spending, subsidies and tax breaks, with a focus on investment in growth industries and national security. A major stimulus package has already been approved.

Crisis-Control Investment/Structural Reforms: The original third arrow of Abenomics was "structural reforms". Takaichi's version focuses on "crisis-control investment" in strategic fields essential for economic security, such as AI, semiconductors, energy and defence.

As well as heightening concerns about government debt sustainability, the policy stance has raised tensions with China, particularly relating to Taiwan.