For context, inflation has been low in Japan since the country’s stock market crash in 1989, and during this time the country has experienced bouts of deflation. Meanwhile, wages started to fall in absolute terms in 1997, and while they bottomed more than 10 years ago, previous peaks have remained out of reach.

Why did deflationary pressures persist for so long in Japan? Our hypothesis is that they were amplified by a combination of demographics and globalisation. ‘Baby boomers’ born between 1947 and 1949 reached their peak earning levels under Japan’s seniority-based wage system around 2000 (just after the domestic financial crisis of 1998). At this point businesses cut back on labour costs by making greater use of ‘non-regular’ workers. Generally, these are cheaper to employ than ‘regular’ workers with indefinite contracts, and also by advancing into China and other overseas markets. 

Japan’s economy stabilised for a while around the mid-2000s, but corporate sentiment took a major turn for the worse – prompting further offshoring – with the Tōhoku earthquake and tsunami of March 2011. These came shortly after the 2008–09 global financial crisis. Wage growth, meanwhile, remained subdued even into the 2010s as businesses needing more workers relied largely on women and seniors, most of whom were only offered non-regular employment.

But the picture is now looking quite different. For starters, the pace of growth of the proportion of seniors in the workforce has been gradually slowing, and baby boomers are soon set to leave the labour market in large numbers as they pass the age of 75. The Bank of Japan of course recognises this, having indicated in its January Outlook report that “wages are highly likely to remain under upward pressure for the time being”, due in part to “the fact that labour supply is widely expected to be constrained mainly by the ageing population in the long run”.

What’s more, female participation rates in the Japanese labour market are now roughly on a par with those in other developed economies, and thus appear to have only limited remaining upside. On top of this, the government has put in place policies to encourage part-time employees to work longer hours, which is liable to be a source of further upward pressure on wages.

Overseas expansion by Japanese businesses – particularly into China – since 2000 was an important factor behind the protracted sluggishness in the growth of domestic prices and wages. However, while former Prime Minister Shinzo Abe sought to promote closer ties with China, there are now growing signs of a deterioration in economic relations between the two countries, with Prime Minister Fumio Kishida having singled out China as “the greatest strategic challenge” for Japan.

China’s share of Japanese imports has barely recovered since falling sharply during the pandemic, while the Japan Bank for International Cooperation’s annual ‘Survey Report on Overseas Business Operations by Japanese Manufacturing Companies’ shows a fall in sentiment towards China. Whereas 37.1% of manufacturers counted China among “promising countries for business development in the next three years” in 2022, that proportion had slumped to an all-time low of 28.4% by the following year, behind India (48.6%) and even Vietnam (30.1%). The Kishida administration’s emphasis on economic security is clearly an important reason for these trends. 

And, manufacturers are no longer demonstrating a ‘deflation bias’ with regard to their selling prices. Until Q1 2021 the Bank of Japan Tankan survey had shown large manufacturers expected their output prices to fall over the next five years, while envisaged five-year-ahead prices were lower than year-ahead prices up until the first half of 2022. However, the latest survey shows that that they expect output prices to: rise by (an admittedly still quite modest) 2.2% over the next year; be 2.8% higher than current levels three years from now; and, 3% higher after five years. 

This shift in inflation expectations among large manufacturers exposed to international competition is likely to reflect a perceived change in the external climate, with ‘deChinafication’ almost certainly at least part of the story.

In October 2023, Prime Minister Kishida identified three trends of change for Japan:

• a shift from a cost-cutting economy that has persisted for 30 years
• a continuing decline in Japan’s population (especially the working-age segment)
• a new era of diplomacy and security “where division and cooperation are intricately intertwined”. 

We see ample scope for the second and third factors to end up serving as catalysts for the first. 

In summary, the demographic trends and geopolitical developments discussed above appear to have significantly reduced the risk of Japan sliding back into deflation. But, more importantly, Japan could now be at a heightened risk of stagflation – increased inflationary pressure coupled with a decline in the potential growth rate – unless a real effort is made to shore up the economy’s supply capacity in the face of diminishing availability of labour and derisking. 

Policymakers at the Bank of Japan and elsewhere in the country will therefore need to recognise that defeating deflation is no longer the sole order of the day.