Our economic outlook for Japan

Japan’s economy is well placed to absorb a further rate increase, with domestic demand proving more resilient and cost pass-through becoming stronger than previously anticipated. GDP continued to expand in the second quarter despite higher interest rates, elevated energy prices, and considerable global uncertainty. Exports have remained resilient, supported by the global AI investment boom, while business investment has been solid amid healthy corporate profits and strong capital expenditure. Real wages have recorded seven consecutive months of growth, supporting household demand and giving firms greater confidence to pass higher labor costs on to consumers.

Inflation is becoming more broad-based and increasingly demand-driven, which strengthens the case for monetary policy action. Consumer price inflation remains around the 2% target set by the Bank of Japan (BoJ), while renewed energy price pressures and earlier yen depreciation have increased the risk of further cost pass-through. More importantly, revised BoJ estimates suggest the economy has been operating with greater demand pressure than previously recognized, consistent with persistent labor shortages, rising wages, and a gradual broadening of inflationary pressures. A continued increase in inflation expectations could introduce the risk of inflation overshooting the BoJ’s price-stability target.

Against this backdrop, a sharp rise in market pricing of further rate hikes is likely to encourage the normally cautious BoJ to shorten its interval between increases to just three months. Our assessment remains finely balanced between December 2026 and January 2027 for the next hike, although we see December as more likely. This would take the policy rate to 1.5% by the end of 2026.