Our economic outlook for Japan

The Middle East conflict poses the greatest growth headwind to Japan given the country’s large exposure to imported energy. This headwind is likely to weigh on growth momentum in business fixed investment and household consumption. Although the economic impact isn’t negligible, it appears to be manageable, reflecting Japan’s ample oil reserves, improved energy efficiency, and structural resilience. Risks would rise materially with weaker global demand or sustained supply disruptions.

Meanwhile, economic fundamentals for future interest rate tightening remain in place. Of particular importance are the annual union wage negotiations—known as Shunto—which are again poised to deliver average pay increases above 5%. This development reinforces Bank of Japan (BoJ) confidence that inflation is durable amid a tight labor market.

Beyond that, AI in an upswinging cycle and fiscal expansion in the form of energy subsidies should partly offset the growth drag from energy headwinds, helping to buttress trend growth.

Higher energy costs are a double‑edged sword. They add to inflation but also weigh on real growth through deteriorating terms of trade, thus arguing for a central bank pause and allowing fiscal tools (e.g., fuel subsidies) to absorb the shock—unless it proves persistent.

With sustained wage growth, the BoJ is laying the groundwork for a gradual resumption of policy tightening this year, having not increased the overnight rate since December 2025. We continue to expect two further rate hikes by the end of 2026, which would take the policy rate to 1.25%. Timing will be data‑dependent, hinging on incoming inflation, wage, and activity data, as well as the persistence of the energy shock.