Simon Kuznets, the Nobel laureate known for his work on standardising the measurement of gross national product, used to group economies into four broad categories: under-developed, developed, Argentina and Japan.
From the 1960s, Japan’s extraordinary growth appeared so unique to Kuznets that it warranted its own category. But, starting in the late 1990s, Japan became an outlier in another way: it was the only advanced economy in the world where inflation, interest rates and wage growth all remained near zero — or in some cases below it.
Now, Japan’s central bankers and government officials say the country is at a historic inflection point and may finally become a “normal” economy. Companies will be able to pass on increased costs to consumers in the form of higher prices, and workers will respond by demanding better pay.
“We have obtained a once-in-a-lifetime historic opportunity to exit from deflation,” Prime Minister Fumio Kishida said at a recent news conference. “We are going to make sure that a positive mindset that will see rising wages as the norm will be firmly established across the entire society.”
Prices in Japan began to rise from the spring of 2022, following the twin shocks of the Covid-19 pandemic and Russia’s invasion of Ukraine. Core inflation, which excludes volatile food prices, rose 2.8 per cent year-on-year in February.
Wages and markets have responded. The country’s largest employers agreed to increase wages by an average 5.3 per cent during this spring’s shunto pay negotiations, the biggest increase since 1991.
In February, the Nikkei 225 stock index finally surpassed a previous peak reached 34 years ago. The following month, the Bank of Japan ended negative interest rates, one of its most controversial monetary policy experiments, raising borrowing costs for the first time since 2007.
Following two years of mild inflation, “the virtuous cycle between rising wages and prices began to emerge and the BoJ started to raise interest rates,” says Tsutomu Watanabe, professor of economics at the University of Tokyo and an expert on inflation measurement. “It’s not complete yet, but Japan is gradually heading towards a normal direction,” he adds.
BoJ governor Kazuo Ueda declared in March that the central bank would be able to carry out “a normal monetary policy” following the end of yield curve control. “People should be living without being conscious of the BoJ’s existence,” he said in an internal BoJ magazine produced by the bank. “We are now at a transition period where we might be able to shift to that kind of a situation if things go well.”
But not everyone is so confident. Some economists point to the slow societal acceptance of the idea of permanently rising prices, while others debate how accurately official economic data reflects the real-world picture. No one is arguing that long-standing structural challenges, primarily demographics and debt levels, have gone away.
“Significant evidence is yet to be seen in terms of real wage rises, ability of households to weather broader price rises, and shifts in consumption, savings and investment choices that would signal that the ‘virtuous circle’ is here to stay,” says Naomi Fink, chief strategist at Nikko Asset Management.
“There is work yet to be done, and evidence yet to be presented by the economy that we have returned to a balanced growth path.”
Japanese officials are certainly not all celebrating the big moment. Instead, many are calling for the central bank to take it slowly from here in, normalising its monetary policy and dismissing the need for the kind of sustained series of interest rates hikes seen in Europe and the US.
Behind their caution are the structural challenges — a shrinking and ageing population and high government debt relative to the size of the economy — and the emergence of deflation elsewhere. China in particular is now grappling with falling prices and a slowdown there would have serious ripple effects on the global economy.
Even though consumer price inflation has been above the BoJ’s 2 per cent target for nearly two years, Kishida has warned that it is premature to declare deflation as over for Japan.
One major concern is the deflationary mindset that has become entrenched in society. “Among senior people receiving pensions, they may wish for inflation to go away because they feel that life was easier when prices did not go up,” says Watanabe. “There is going to be a force of resistance. As the broader mindset is starting to change, the number of people who don’t want things to change will be relatively large.”
Japan’s sluggish economic performance has not helped with changing this stance. According to a recent poll by the Cabinet Office, a record 63.2 per cent of those surveyed said they did not feel financially secure.
Consumption also remains weak while the yen, its movements primarily driven by US monetary policy and the strength of the dollar, has fallen to its lowest level in 34 years as investors expect Japan’s interest rates to remain close to zero even as rates in the US and elsewhere remain elevated.
“The economic conditions are not yet in place [for monetary policy normalisation],” says Sayuri Shirai, a former BoJ board member and a professor at Keio University. “The fact that the BoJ decided to move based on spring wage talks alone shows that they were in a rush to end negative interest rates.”
According to Shirai, one major source of uncertainty is whether the sharp wage increases by Japan’s largest companies will trickle down to small and medium enterprises. These employ 70 per cent of the country’s workers and have much less scope to raise pay, invest in automation or find other productivity gains than their larger counterparts.
Following the robust wage talks, some economists are hopeful that real wages will start to rise from the summer, which should then help to boost consumption.
But Shirai notes that a surprisingly strong wage increase of 3.6 per cent last spring only translated into growth in average cash earnings of 1.3 per cent between April and December. That was less than the 1.9 per cent registered during the same period in 2022 and represented a decline in real terms, due to higher inflation.
For Mikihiro Matsuoka, chief economist at SBI Securities, the question of Japan’s normality as an economy will in large part be answered by the services sector, where import prices, the weak yen and energy volatility are less relevant.
“Do we have a transmission mechanism from wages to prices, or from prices to wages?” he asks. “I would say not yet.”
Matsuoka cautions that there have long been issues in assessing how broad-based services inflation is. Unlike the US and other developed economies, he says Japan cannot rely on signals like house price increases or rising rents and must instead depend on a bottom-up and sometimes deceptive assessment of relatively large subsectors of the economy.
Izumi Devalier, Bank of America’s head of Japan economics, says that the evidence from these remains patchy. “We are seeing some of the tourism-facing industries hiking prices, and the train companies raising fares,” she acknowledges.
“But we are not seeing a sufficient breadth of increases to be sure that inflation is firmly anchored,” she adds, noting that the government had begun trying to encourage smaller companies to push back against larger ones and demand higher prices for their services.
Those who argue that permanent service price inflation is now all but guaranteed point to Japan’s demographics and labour shortages. In theory, they should grant greater bargaining powers to workers as companies compete for staff.
“The huge pay increases hitting the news wires in recent weeks suggest a degree of white-knuckle terror among Japanese managers, fearing not only that they might lose the intensifying tug of war over new hires, they might have to deal with an exodus of mission-critical employees,” says CLSA Securities Japan strategist Nicholas Smith.
There is some evidence that this is happening. In January, the credit research group Tokyo Shoko Research reported a 35.2 per cent year-on-year increase in bankruptcies of businesses with debts of over ¥10mn ($66,000) during 2023, with the burden of higher wages driving a significant part of that. Bankruptcies rose in all industries covered by the survey but the rate of increase was highest in the construction and services sectors, where labour cost increases have hit hardest.
But Devalier points to the continuing propensity of Japan’s companies to absorb inflationary pressures before transmitting them into price increases. One effect of labour shortages, she says, could be that waiting times for various services lengthen, indicating inflationary pressure that is yet to be expressed as higher wages for workers or higher prices for customers.
Matsuoka believes the central bank’s decision to, in effect, treat Japan’s economy as normalised was premature and not based on the reality of a still-stagnant business cycle. The declining numbers for public works, machinery orders and construction starts, he says, made it a “strange time” to be tightening.
Watanabe adds that the BoJ’s pledge to continue buying about ¥6tn of 10-year Japanese government bonds each month was a further sign that normality in monetary policy is still some way off.
Like its economy, Japan’s stock market has for many years been regarded by global fund managers as unique among its developed-world peers.
Big Japanese companies tended to retain large crossholdings in other listed companies and around half of all companies traded below the book value of their assets. The primacy of shareholder interests common elsewhere was less prevalent in Japan and the market displayed an unusual tendency to revert to a long-term average rather than embark on sustained moves higher or lower.
Even more unusually the market was detested by ordinary Japanese investors. They have dumped around ¥70tn of domestic shares in the 34 years since the Nikkei’s last peak and keep over half their total financial assets in cash and deposits.
For many years, when consumer prices were stagnant or falling, that was perfectly rational: why bother taking equity risk if your cash was not losing any real value?
But as inflation has picked up, that logic no longer holds: savers can see prices rising and the purchasing power of their cash falling. For the first time that many can remember, they need to think about yield and returns.
At the same time, Japanese stocks have entered an unusually long bull market, driven by narratives about corporate behaviour moving closer to global norms. Suddenly, say market analysts, individuals are taking a greater interest in financial markets.
The government has done its bit, dramatically increasing the size of a tax protected investment scheme — the Nippon Individual Savings Account (Nisa) — from the start of 2024.
Masatoshi Kikuchi, chief equity strategist at Mizuho Securities, says that as of December 2023, Japanese savers had collectively opened 21.3mn Nisa accounts and poured ¥35.4tn into them. Separate data from the Japan Securities Dealers Association showed more than half a million new Nisa accounts were opened in February 2024, while recent BoJ numbers indicate that the value of stocks and investment trusts held by households now stands at ¥382tn, up 27 per cent in the past year.
Mergers and acquisitions are becoming more commonplace, while the Tokyo Stock Exchange has mounted a serious-looking campaign to pressure companies into concentrating on their cost of capital and their returns on equity.
In the light of all this, growing numbers of global investors have warmed to the idea of reassessing Japan as a market where companies’ share prices are driven by the same factors that apply elsewhere.
Bruce Kirk, chief Japan equity strategist at Goldman Sachs, says there is still a definite split between those who expect Japan to continue to mean-revert and those who think that the normalisation of the Japanese economy means investors can now safely compare its markets to those elsewhere.
“At this stage of the rally, most sectors are trading at, or close to, their medium-term highs, so there is definitely a search out there for a new benchmark,” he says. “Monetary policy has normalised, deflation appears to have ended, wages are rising again, and we’re in the middle of a massive value unlock programme courtesy of the TSE. So there are a lot of new factors in play at the moment,” he adds.
Economists argue that the behavioural changes among Japanese companies and their employees are the most striking signals of Japan’s potential return to normality.
Take beverages producer Asahi, which raised the price of its canned beer products for the first time in 14 years in October 2022. “We were quite encouraged,” said Atsushi Katsuki, chief executive, in an interview with the FT in March. “Ultimately, consumers are willing to pay the price if they see value.”
Labour experts say there are signs of a historic switch in the relationship between companies and their employees, with the docility that had taken over Japanese labour unions during the past three decades increasingly replaced with more robust confidence as labour shortages strengthen their hand.
Katahiro Yasukochi, chair of the Japanese Association of Metal, Machinery and Manufacturing Workers, which consists of about 390,000 workers mostly employed by small and medium-sized enterprises, says companies that plead poverty when faced with demands for higher wages should raise the prices of their products and services.
“We feel that we need to achieve a society where 2 per cent inflation and 3 per cent wage increases will always be achieved,” he says. “This isn’t just about next year but over a long span of time such as five or 10 years.”
Company executives agree that repeated wage hikes will be needed for the impact to filter through broader society. “The purse strings will not loosen until the wage hikes permeate and people feel less insecure about their future,” says Masamichi Terabatake, chief executive of Japan Tobacco.
“For all of this to accelerate the economy, it will take a bit more time.”