Amid geopolitical fragmentation and global financial market volatility, Japan is transitioning into a new economic era. Deflation now seems like a distant past, with underlying inflation and inflation expectations rising well above zero. The ultra-loose monetary policy of the Bank of Japan (BOJ) has ended. Policy rates are rising, and asset purchases are being tapered. Growth momentum has improved, and nominal wages continue to rise.

While the transition is ongoing, high public debt—the legacy of the past—continues to weigh on Japan, even though the public debt to GDP has declined from its peak in 2020. The global environment has also been unforgiving. Trade uncertainty persists despite a deal with the US, while jittery financial markets have led to sharp swings in the yen and pushed long-term bond yields to a 27-year high. AMRO’s 2025 Annual Consultation Report on Japan discusses the ongoing transition, outlook and way forward. The key takeaways from the report, released today, are as follows.

1) Growth has firmed up, while inflation momentum has strengthened

Japan’s 2025 GDP growth is estimated at 1.2 percent, supported by robust business investment and private consumption. Growth is expected to moderate to 0.8 percent in 2026 as the full impact of tariffs materializes and the effects of export front-loading fade. Domestic demand is set to remain the main growth engine.

Inflation, which spiked in 2025 due to food supply shocks and higher import costs from a weak yen, is expected to ease. Nevertheless, strong nominal wage growth is likely to persist into 2026 amid a tight labor market and continued government support. Core inflation (CPI excluding fresh food) is projected to decline from 3.0 percent in 2025 to 2.2 percent in 2026.

2) Several risks to growth remain on the horizon

The near-term growth outlook is clouded by several risks, including a further escalation of US protectionist measures, a sharper global slowdown, heightened geopolitical frictions that could disrupt trade, tourism, and supply chains, and renewed commodity price shocks. The economic impact of the USD 550 billion investment initiatives in the US remains uncertain.

Japan also remains exposed to more volatile global financial conditions. Over the longer term, high public debt and rising interest rates pose fiscal challenges, while population aging and climate-transition spending could further constrain growth potential and fiscal space.

3) Monetary policy normalization should remain gradual, data-dependent, and well communicated

The current policy rate of about 0.75 percent implies a negative real interest rate that remains below the natural rate, as estimated by the BOJ. While a positive output gap, elevated inflation, and rising inflation expectations justify further rate hikes, the pace of tightening should be guided by the growth outlook, wage-price dynamics, the impact of US tariffs, and underlying inflation trends.

Policy rate increases have been transmitted to market and bank lending rates, while bond yields have continued to rise. Our analysis shows that Japanese banks have improved their resilience to rising interest rates. Alongside measured rate adjustments, the ongoing tapering of BOJ government bond purchases—and the planned sales of exchanged-traded funds and real estate investment trusts—should continue to emphasize predictability, clear communication, and operational agility amid heightened uncertainty and a market volatility.

4) Fiscal policy should address near-term risks while sustaining medium-term consolidation

Fiscal policy should remain agile and targeted, striking a balance between near-term growth support, medium-term consolidation, and long-term structural needs. In the face of external headwinds, targeted assistance for vulnerable groups is warranted, while broad-based stimulus should be avoided given fiscal risks.

With population aging and climate transition likely to add to spending pressures, continued medium-term consolidation—through revenue mobilization and expenditure rationalization—is essential to contain public debt. AMRO’s debt sustainability analysis underscores the need for medium-term fiscal consolidation, showing that public debt dynamics are highly sensitive to growth and interest-rate shocks.

5) Structural reforms are essential to lift productivity and sustain growth

A multi-pronged structural reform agenda will be critical to sustaining productivity gains and affirming Japan’s transition into a new era of revitalized growth. Priorities should include fostering innovation, accelerating technology adoption, and strengthening human capital investment. Enhancing labor market flexibility, alongside continuous upskilling and reskilling, can help ease labor shortages, boost productivity, and support real wage growth.

At the same time, a dual focus on advanced manufacturing and high-value services, through greater “servicification”, can broaden growth drivers and further lift productivity. Delivering these reforms will require strong government support and effective cross-ministerial coordination.

Conclusion

While several years of policy efforts are beginning to bear fruit and Japan is entering a new phase of economic transition, significant challenges remain. With global uncertainty likely to persist, strengthening domestic growth engine alongside necessary reforms will be essential to place Japan on a firm path toward renewed prosperity. Careful policy calibration to balance growth momentum and stability will be key.