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Has inflation returned to Japan?

Written by Charles Zuo Qizhen and Data Visualization by Bryan Wee
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For the past two years, economies around the world have suffered from high and persistent inflation, due to lingering supply disruptions from the pandemic, a permanently reduced labour force, and the food and energy crisis from Russia’s war on Ukraine. In response, major central banks hiked interest rates aggressively, with policy rates remaining elevated at the end of 2023 (Figure 1). 



Figure 1: Central bank policy rates in major economies. Source: Bank of International Settlements


Interestingly, the Bank of Japan (BOJ) is an outlier with a policy rate of -0.1%. Why is the BOJ creating inflation when the rest of the world is working so hard to bring it down? This article uncovers Japan’s unique economic problems that have called for the use of unconventional monetary policies. In light of recent developments, the BOJ’s ultra-loose policy stance is set to change for the first time in nearly 30 years. 


Struggles with deflation and low inflation

Japan’s economic situation today stems from the bursting of a massive asset bubble in the early 1990s that caused a collapse in stock and property prices. Subsequent contractions in economic output led to prolonged stagnation from the 1990s to the 2010s, a period known as Japan’s “Lost Decades”.




Figure 2. Source: Bank of Japan Policy Statements (2013 - 2023)


During this period, the BOJ experimented with unconventional monetary policies in desperate attempts to stimulate economic growth. The large negative demand shock pushed the economy into a deflation trap, characterised by continuously falling output and inflation. The BOJ’s Zero Interest Rate Policy (ZIRP) launched in the 1990s was ineffective as negative inflation meant real interest rates in the economy were significantly higher than zero. This is due to the relation between real and nominal interest rates given by the Fisher Equation: r=i-e. Thus, the BOJ pioneered Quantitative Easing (QE), in which the central bank creates money to buy financial assets, hence lowering long-term interest rates and boosting money supply.



Figure 3: Year-on-year change in Japan’s CPI. Source: Ministry of Internal Affairs and Communications


In April 2013, the BOJ introduced Quantitative and Qualitative Easing (QQE) and signalled its commitment to achieving a price stability target of 2% as soon as possible. While QQE succeeded in pulling the Japanese economy out of chronic deflation, inflation remained sluggish. Core CPI (red line in Figure 3) measured well below the 2% target leading up to the pandemic. The reason for this? Inflation expectations.



Figure 4 The IS-PC-MR 3-equation model: PC = Phillips Curve, πe= Expected Inflation, ω = Real Wage, WS = Wage-Setting Curve, PS = Price Setting Curve. Assume an economy initially operating at A with low growth y0 and low inflation 𝜋0

15 years of deflation have deeply entrenched expectations of low inflation in people’s minds. Using the 3-equation New Keynesian macroeconomic model, upward shifts in the Phillips Curve were small despite the positive output gap created by the central bank. Inflation was also dampened by wage and price setting behaviours. Influenced by low inflation expectations in the economy and fearing the loss of customers, Japanese firms were reluctant to pass on cost increases in the form of higher prices. Meanwhile, long periods of high unemployment during the deflation trap led to workers and firms prioritising employment stability over immediate wage increases. As a result, PC and WS flattened, causing nominal wage growth to stagnate despite tighter labour market conditions (Figure 4).


Negative interest rates and yield curve control

With its renewed objective of fighting persistently low inflation, the BOJ introduced negative short-term interest rates and Yield Curve Control (YCC) in 2016. Under YCC, the BOJ sets a target interest rate (yield) of 0% for 10-year Japanese Government Bonds (JGB) and buys 10-year JGBs when their yields approach the upper bound of the tolerance band. This pushes JGB yields, which move inversely to their prices, back down. 


Fast forwarding to 2022-2023, the -0.1% policy rate and YCC have remained in effect. However, Japan has not been immune to inflationary pressures felt worldwide, as the economy experienced CPI growth of more than 2% for the first time in decades. There has been much speculation over the BOJ’s exit from ultra-loose monetary policy, since the current economic situation represents a potential turning point for an economy mired in low inflation for so long.






Figure 5: USD/JPY and 10-year JGB yields over a one year period from 5 Dec 2022 to 5 Dec 2023. 

Sources: NASDAQ, 

The BOJ’s dilemma

Sticky inflation globally has put the BOJ in a tough spot. Central bank rate hikes since 2022 and the recent October surge in US Treasuries have exerted upward pressure on 10-year JGB yields, forcing the BOJ to purchase large volumes of JGBs to keep JGB yields within YCC’s tolerance band. Such manoeuvres have been costly. In January 2023, the BOJ made bond purchases exceeding 13 trillion Yen ($100 billion) in one week to defend YCC.


Large policy rate differentials between the BOJ and other central banks have also weakened the Yen significantly (Figure 5), fueling imported inflation. To make YCC more sustainable and defend the falling Yen, the BOJ has made gradual adjustments to YCC (see (1), (2) and (3) in Figure 2), signalling an intention to tighten monetary policy as Japan revives inflation.


Essentially, the BOJ is pressured to tighten monetary policy in line with the rest of the world. However, a premature tightening risks putting Japan’s economy back into its malaise of low growth and low inflation. Thus, Japanese households have had to cope with elevated living costs while the BOJ remains reluctant to tighten policy. 


What does policy normalisation look like? 

The trajectory of prices and wages in the economy is the top concern for the BOJ as it continues to mull over its exit from YCC and negative interest rate policy. According to BOJ governor Kazuo Ueda, the BOJ is looking for a virtuous wage-price cycle as ‘conviction that sustained achievement of our (2%) price target comes into sight.’


So far, there have been promising signs in the labour market. Unions won the highest nominal wage increase in 30 years at the annual Shunto wage negotiations with management that took place in April 2023. Companies including Meiji Yasuda Life Insurance Co. and Suntory Holdings Ltd. are reportedly targeting nominal wage growth of up to 7% for Shunto 2024.


With CPI growth above 2% for 19 consecutive months, firms have become more willing to pass on cost increases and set higher wages. Together, rising wages and prices potentially create the  virtuous wage-price cycle that positions Japan to achieve 2% inflation.



Figure 6: Real wages in Japan have been falling for 18 straight months


For 2% inflation to be sustained however, it has to be driven by rising real wages and demand. Real wages have been falling in Japan (Figure 6), indicating inflation is largely cost-push in nature and wages have not grown sufficiently to overtake rising prices. In addition, a virtuous wage-price cycle must be cemented by stable inflation expectations. The BOJ must therefore ensure positive shifts in expectations and wage and price setting behaviours are permanent before fully normalising policy. 


The BOJ’s policy normalisation will have major implications. Japanese investors are among the largest holders of foreign bonds. A rise in yields that make JGBs more attractive could trigger large reversals of flows that wreak havoc on financial markets. With Japan being such an influential driver of global markets, it is paramount for the BOJ to continue its conservative approach towards exiting decades of loose monetary policy and usher in a new era of healthy inflation and economic growth.  

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