How the return of inflation is changing Japan’s economy


In a little over two years, Japan appears to have put three decades of deflation decisively behind it. Accelerating from near zero at the start of 2022 to a peak of over 4% early last year, consumer prices are currently just shy of 3%.

A weak yen, still easy monetary policy and a jump in salaries that is seeing real wage growth turn positive are leading to a broad-based increase in prices that started in goods, especially imports, but has now spread to services. 

In other words, inflation is, at last, embedding itself into the economy. At Societe Generale, we are forecasting that the consumer price index will weaken slightly through this summer but stay at, or slightly above, 2% for the foreseeable future – very much what the monetary authorities would like to see! 

Consumers: a boost for housing and shares

So, what are the long-term effects of Japan emerging from deflation after so many years? The first is a likely shift in consumer psychology. As prices rise, households are expected to run down savings, particularly in cash, and increase spending and, more importantly, investment into real (in other words, inflation-proof) assets. 

Older, wealthier people will favour financial assets, in particular equities, taking advantage of the government’s expansion of the tax-free NISA savings scheme. Younger households are being encouraged to do some of that as well. But their top priority is to buy a house. This is a big change in a country where a large proportion of the population rents and which has missed out on the real estate boom that has swept across most developed economies over the past 20 years.

The fact that Japanese consumers have therefore had less of their net worth invested in either stocks or property explains the country’s relatively weak wealth effect – which has contributed to economic stability but also made deflation harder to shake. If this changes over the next decade or two, Japan’s economy may start to behave more like those of the UK or US: with more volatility but perhaps also an ability to recover more quickly from shocks and to build wealth more rapidly.

Corporates: invest or decline

For the corporate sector, the imperative is clear: increase investment. The return of inflation is allowing companies to raise prices again, but input costs are rising too and often more quickly and sharply. This is prompting firms to focus on and develop more high-margin products, which requires investment as well as more research & development spending.

At the same time, a rising cost of debt and the impact of corporate governance reforms are forcing them to raise returns, which generally means investment to renew assets, increase efficiency and refresh product lines. We calculate that the companies comprising Japan’s Topix index average a 10% return on equity compared to 15-20% for the US S&P500, with European returns somewhere in the middle. Japanese corporates are seeking to close that gap.

Finally, the country’s demographics are pushing them in the same direction. A declining labour force is leading to more investment in automation, robotics and, latterly, artificial intelligence. Meanwhile, shrinking domestic demand means companies are having to prioritise overseas markets and build local manufacturing hubs and supply chains. 

Japan’s corporate sector, particularly multinationals in sectors like consumer electronics, have lost ground against international rivals in recent years. But they have lost none of their underlying manufacturing or research skills and if they step up investment and focus on returns, we believe they will regain ground.

Government: a manageable debt burden

For the public finances, the fact that inflation will drive up the cost of servicing Japan’s enormous debt load – the highest of any developed nation at over 260% of GDP – is a real concern. However, we believe that government finances will remain sustainable as long as inflation exceeds the level of 10-year government bond yields – which is the case currently.

The reason for that is that inflation is also increasing tax revenues as households see an increase in wages and corporates an increase in profits. So as long as the Bank of Japan is cautious in managing a gradual tightening of interest rates, the growth in tax receipts should continue to cover a rising public interest bill.

In fact, therefore, inflation should actually lead to a gradual improvement in government income. A more difficult question is whether this will encourage the administration to tackle much-needed structural reform. As we have long argued, Japan is making progress in removing structural rigidities in the labour market as well as improving corporate governance. 

But there is more to do, particularly in overhauling healthcare, pensions and education. Such reforms are difficult and expensive and ultimately will probably require tax increases to fund them. There is little sign that the current administration is willing to take on this challenge. But as inflation reshapes the structure of Japan’s economy and, to an extent, national thinking as well, we remain hopeful. 

Tsutomu Saito Multi Asset Strategist Societe Generale Securities Japan Limited