A fragile transition from deflation to inflation
For decades, Japan has lived under the shadow of stagnation — years of weak growth, deflationary pressures, and constant monetary intervention. The so-called Lost Decades were marked by near-zero interest rates, massive government debt, and persistent efforts by the Bank of Japan (BoJ) to reignite both inflation and domestic demand.
Today, however, the landscape has changed dramatically. Inflation, long considered an elusive goal, has returned — and with it, a new set of challenges. According to BoJ projections, the core Consumer Price Index (CPI), excluding fresh food, is expected to rise between 2.5% and 3.0% annually in 2025. In July, headline inflation reached 3.1%, exceeding the central bank’s 2% target. Yet, excluding food and energy, underlying inflation sits closer to 1.6%, suggesting that part of the current price pressure remains transitory.
Still, the psychological barrier has been broken: for the first time in decades, Japan’s inflation is persistently above target. This shift has created a policy dilemma for the BoJ — whether to continue its ultra-loose stance to support growth or begin tightening to prevent long-term damage to purchasing power and financial stability.
The BoJ’s monetary expansion: power and pitfalls
The Bank of Japan’s approach to monetary policy has been among the most aggressive in the world. For years, it has relied on zero or negative interest rates, vast purchases of government bonds, exchange-traded funds (ETFs), and corporate debt — all designed to inject liquidity and spur demand.
But every expansionary policy carries side effects. A flood of liquidity depresses the value of the national currency. The yen’s prolonged weakness — it hovered around record lows against the U.S. dollar through 2024 and 2025 — has made imported goods, energy, and raw materials significantly more expensive. For a resource-poor nation like Japan, this imported inflation translates directly into higher consumer prices.
Meanwhile, wage growth has failed to keep up with inflation. Real wages — adjusted for price increases — have fallen for months in a row. As of August 2025, they were down 1.3% year-on-year, marking the eighth consecutive month of decline. This steady erosion of purchasing power is squeezing households, curbing discretionary spending, and dampening overall consumer confidence.
Furthermore, prolonged monetary easing has distorted asset prices. The risk of speculative bubbles in real estate or equity markets looms large, recalling the 1980s’ asset price bubble — a painful reminder of how monetary exuberance can spiral into crisis.
The consumption crisis: inflation versus stagnating wages
Domestic consumption — the backbone of Japan’s economy — is now under strain. Despite low unemployment and tight labor markets, household spending is weakening. The BoJ’s latest reports describe consumption as “resilient but fragile,” citing higher prices as the main drag.
In practical terms, Japanese families are cutting back on non-essential goods and services: fewer vacations, less dining out, delayed purchases of cars or appliances. Retailers are feeling the pinch, and so are small businesses. This behavioral shift has macroeconomic consequences — when consumption weakens, so does GDP growth.
Recent data suggest that Japan’s real GDP contracted by 0.2% (annualized) between the last quarter of 2024 and the first of 2025. Analysts point to slowing global demand and reduced export momentum, alongside the inflation-driven decline in domestic consumption.
The risk, economists warn, is a mild form of stagflation — a combination of weak growth and stubborn inflation. Prices are rising, yet consumers feel poorer. It’s a delicate scenario that neither aggressive stimulus nor sudden tightening can easily fix.
BoJ’s balancing act: to tighten or not to tighten
The Bank of Japan finds itself trapped between two imperatives. On one hand, it must avoid choking the fragile recovery; on the other, it must prevent inflation from eroding household income.
So far, the BoJ has opted for gradualism. In its recent meetings, it kept its policy rate at 0.5%, while signaling the possibility of a slow normalization. Officials have hinted at a potential move to 0.75% in the coming months if core inflation remains above 3%.
However, rapid tightening could have dangerous side effects. Japan’s public debt exceeds 250% of GDP, the highest among major economies. Even a modest rise in interest rates would significantly increase debt-servicing costs, straining public finances. Corporate borrowers and mortgage holders would also feel the squeeze.
In this context, the BoJ prefers to proceed cautiously, guided by data on inflation persistence, wage growth, and consumption patterns. Yet patience has its risks: maintaining ultra-loose policy for too long could weaken the yen further, fueling a new wave of imported inflation.
Structural weaknesses: demographics and productivity
Beyond cyclical pressures, Japan faces deep structural headwinds. Its aging population is perhaps the most serious challenge: a shrinking labor force and rising dependency ratios limit growth potential and fiscal flexibility. By 2050, nearly 40% of Japanese citizens will be over 65, making Japan the world’s oldest society.
This demographic imbalance constrains domestic demand and discourages investment in long-term projects. At the same time, it suppresses wage dynamics: with fewer workers and tepid productivity growth, companies remain reluctant to raise salaries sustainably.
Adding to the problem is the flattening of the Phillips curve — the relationship between unemployment and inflation. In Japan, low unemployment no longer translates into higher wages, making it harder for inflation to become self-sustaining through stronger income growth.
Meanwhile, the BoJ’s massive bond holdings — now exceeding half of Japan’s GDP — have distorted the bond market, leaving little room for natural price discovery. If the central bank starts unwinding its portfolio, it risks destabilizing markets; if it doesn’t, it perpetuates inefficiencies.
The external dimension: a weaker yen and trade imbalances
A depreciating yen has mixed effects. On paper, it boosts exporters by making Japanese goods cheaper abroad. In reality, however, the global slowdown and higher input costs limit these benefits. Many Japanese manufacturers depend on imported materials and components; a weak yen inflates those costs and narrows profit margins.
For consumers, the impact is unambiguously negative. Energy, food, and imported goods are pricier, further reducing real income. The result is a transfer of purchasing power from households to exporters — and from consumers to the government, which benefits from debt inflation.
Japan’s external balance remains in surplus, but the quality of that surplus is changing. Instead of strong industrial exports, it increasingly depends on financial income and overseas investments. This transition reflects a broader vulnerability: Japan’s strength lies not in its domestic dynamism but in its external assets.
The political and social dimension
Economically, Japan’s monetary expansion has been a cushion; politically, it has become a liability. Ordinary citizens see rising prices, stagnant wages, and declining living standards. The government faces growing criticism for prioritizing market stability over household welfare.
The BoJ’s credibility, long unquestioned, is also under scrutiny. Some economists argue that the central bank has become too dependent on its own policies — trapped in a cycle where any exit threatens to expose fragilities it helped create.
If inflation expectations become entrenched while wage growth remains subdued, public discontent could translate into political volatility — a rare but not impossible scenario in a country that values stability above all else.
Looking ahead: the search for equilibrium
Japan’s current crisis is not one of collapse, but of balance. After decades of fighting deflation, the country now faces the opposite problem: how to tame inflation without strangling recovery.
To restore equilibrium, Japan needs a multi-dimensional strategy. Monetary policy alone cannot fix structural issues. The government must invest in productivity, technological innovation, and labor participation — particularly among women and older workers. Fiscal reforms that channel spending toward long-term growth, rather than mere stimulus, are essential.
For the BoJ, the path forward will involve carefully unwinding extraordinary measures while preserving financial stability. Gradual rate hikes, combined with targeted support for vulnerable sectors, could prevent a hard landing.
Ultimately, Japan’s future hinges on whether it can transform this inflationary shock into an opportunity — to rebuild confidence, encourage wage growth, and rejuvenate domestic demand.
If it succeeds, the current turbulence may mark the end of its deflationary era. If it fails, Japan risks sliding into a new, more complex stagnation — one defined not by falling prices, but by a loss of economic vitality and public trust.