In 2016, a Japanese ice cream company made national headlines, not for a product launch, but for an apology. Executives from Akagi Nyugyo bowed deeply on television after raising the price of its popular GariGari-kun ice pop by just 10 yen (~10 cents NZD). It was the first increase in over 25 years, and the apology reflected a deeply ingrained reality: in Japan, prices simply did not go up.
Over the past five years, however, that reality has changed. Prices in Japan, measured by the consumer price index, have risen 13.1%. In the previous five years, they increased a mere 2.1%. In our view, structural changes within the Japanese economy suggest that a higher level of inflation is now sustainable.
The labour market is a key driver. Japan’s unemployment rate sits at just 2.7%, with participation well above other developed economies. Every industry captured in the Bank of Japan’s (BOJ) Tankan survey reports facing labour shortages. This scarcity of workers is forcing structural change. Companies are moving away from the traditional “lifetime employment” model and competing more aggressively for new talent, particularly younger workers. Wage growth is strengthening after a long period of stagnation. Last year’s Shunto negotiations (covering around 8% of the workforce) delivered wage increases of around 5%, and this year’s negotiations are expected to produce similar outcomes.
As a result, labour-intensive services, dining, and even previously “untouchable” staple goods are now seeing sustained price increases. Importantly, service inflation, long dormant in Japan, has picked up meaningfully and is now running closer to levels consistent with the BOJ’s 2% target. Inflation expectations are also shifting, with businesses and consumers increasingly accepting that higher prices are here to stay.
Yet despite these positive shifts, consumers remain under pressure. Real wages (wage growth adjusted for inflation) are still negative, exacerbated the weakness of the Japanese yen which is down ~32% against the USD over the last 5 years. This has lifted import costs and eroded purchasing power. Fiscal support, such as a recent stimulus package equivalent to roughly 2.8% of GDP, may help cushion households, but it does not address the underlying issue. Without a stabilisation or appreciation of the yen, wage gains may continue to be offset by rising living costs.
Interest rate policy may be Japan’s “golden ticket”
A stronger yen is unlikely without higher interest rates. The wide gap between Japan’s ultra-low policy rate (0.75%) and tighter global policy rates (US policy rate is 3.75%) has been a major driver of currency weakness. Recent developments suggest policymakers are increasingly aware of this. The BOJ’s December hike to 0.75% was accompanied by growing confidence that inflation is becoming more durable and that the wage–price cycle is strengthening.
Importantly, the Bank has also acknowledged that real interest rates remain “significantly low”, implying further tightening is likely if economic conditions continue to improve. Market pricing is already reflecting this shift, with expectations for policy rates to rise toward ~1.5% over the next few years.
Higher rates would serve a dual purpose. First, they would help stabilise the currency, easing imported inflation and supporting real incomes. Second, they would reinforce the credibility of the central bank, helping to anchor expectations and avoid an inflation overshoot driven by persistent currency weakness.
Crucially, Japan is better positioned to absorb higher rates than many assume. Corporate profits are strong, capital expenditure is rising, and balance sheets across the private sector remain healthy. The combination of tight labour markets, ongoing investment, and supportive fiscal policy suggests the economy is resilient enough to handle gradual normalisation.
The alternative is far riskier. Keeping policy too loose risks continued negative real wages, weakening consumption, and undermining confidence.
There are, of course, risks. A slowdown in global growth could strengthen the yen and reduce the need for further hikes. Inflation may also moderate in the near term as food price effects fade. Political pressure could also influence the pace of tightening. But none of these alter the broader direction: Japan is moving away from deflation, and policy must adjust accordingly.
If managed well, this transition could mark a turning point. A stronger yen would ease cost-of-living pressures. Positive real wage growth would support consumption. Investment would continue to expand. And Japan could finally move beyond its deflationary past toward a more balanced and resilient growth model.
In that sense, higher interest rates are not a constraint on Japan’s future, they are the key to it.
Within our Global Fixed Income fund, we are positioned underweight Japanese interest rate risk, with the expectation interest rates will continue to rise.
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