Japan's Rising Interest Rates and Prices: Behavior change could help

Cost reduction has been top priority for Japanese businesses* for the past three decades. This was justifiable during deflationary periods, but in the face of rising prices and interest rates, cost cutting alone fails to meet the expectations of investors and lenders; both seek high returns. Businesses that fail to achieve a sufficient profit margin face being weeded out of the market as investors pull out. Further, those whose wage increases cannot keep up with inflation will struggle with labor shortages as their workers go elsewhere.

That being said, consumer price increase taking hold does bring a few benefits; for one, businesses have an easier time setting, and raising, prices for their products. They should take this opportunity to invest in the latest technologies and human capital for greater added value, as well as improve their profitability through appropriate cost pass-through.

For example, if a business were to streamline work processes by deploying artificial intelligence, the freed-up resources could be utilized in adding value to existing products and services or planning new businesses. Workforce-facing initiatives too will become more important than ever such as wage increases to secure technically skilled personnel, a wage structure based on skill levels, and internal training programs.

Japan has enjoyed low interest rates for years. The government could raise its debt free from proportional hikes in interest payments. And it did: Bonds were repeatedly issued to fund large-scale economic stimulus measures. This swept the country from 180 trillion yen in bond debt to over one quadrillion yen in the past 30 years.

Expenditures to service national bonds are bound to spike when interest rates go up. The fiscal balance could temporarily improve thanks to tax revenue growth gained in the early stages of rising prices and interest rates, but expenses will inevitably increase as current bonds mature and the government refinances with higher interest rate bonds. The Ministry of Finance estimates that raising interest rates by a single percentage point will add 2.5 trillion yen to government bond expenses in three years’ time. Compared with pre-pandemic levels, the ten-year yield for government bonds has risen by one point, making this scenario increasingly realistic.

The government will lose public confidence in how it manages its finances if it fails to take more care with its fiscal policy. And this might cause consumers to tighten their belts further amid a heightened sense of crisis^†. Instead of broadly redistributing temporary tax revenue increase to households in the form of tax cuts, the government must use the gains to achieve fiscal soundness and reduce debt, thereby relieving consumer anxiety in the longer term.

If the government, businesses, and households can break away from behaviors established during Japan’s period of deflation, the flow of funds of the economy as a whole will change in a way suited to sustained growth. As shown in Figure 1, investment since 1998 has been government-led, with the government playing the main role in funding and supporting growth. Moving forward, we hope to see private sector investments driving economic growth, just as they did up to the first half of the 1990s.^‡

In this context, the government can stimulate investments from the private sector by making policy more predictable, thereby lightening the fiscal load. We see both rising prices and interest rates as an opportunity for all three groups to change their behavior, making economic growth sustainable.