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

22 March 2024

Japanese version: 1 January 2024

Kenta Domoto
Center for Policy and the Economy


  • Behavior change is required in all sectors to maintain economic growth as the population shrinks
  • It is more crucial than ever for businesses to up their investment in physical and human capital if they are to better their profit margins
  • The government must prepare for higher national-debt service expenditure, and households must bolster for dwindling asset value

The first step toward economic growth amid a shrinking population: shedding behaviors that set in under deflation

After escaping the grips of deflation, Japan’s next task will be to achieve sustained economic growth. However, we find ourselves in a very different economic situation than when the country first fell into chronic deflation in the early 1990s. Most crucial is how the demographic makeup differs.

The Japanese economy can no longer rely on expansion of its population, and thus workforce and consumer markets, to grow. All—businesses, government, and households—must shed behaviors that set in under the deflationary environment if the country is to achieve both stable price increases and sustained economic growth amid a shrinking population.

Businesses need to invest in their workforces and set appropriate prices

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.

*With regard to reduction of labor costs, labor share fell from 75.7% in fiscal 1999 to 67.5% in fiscal 2022 (source: Ministry of Finance, Financial Statement Statistics of Corporations by Industry; the survey covers all industries and businesses of all sizes excluding the finance and insurance sectors). Investment in growth was also curtailed during this period, and cash and deposits on hand increased by almost 90% (source: Bank of Japan Flow of Funds Accounts; survey includes non-financial businesses)

Government needs to rethink its fiscal policies

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.

In a survey conducted by Mitsubishi Research Institute, Inc. (MRI) in 2023, only 20% of households believed that the government could avert a fiscal crisis. The survey used MRI’s Market Intelligence & Forecast System (mif) and saw responses from 2,000 individuals from October 28-29, 2023

Households need to invest in inflation resistant assets

Households must change their view that cash and deposits are the safest way to invest. Inflation means a decrease in their purchasing power. Inflation at 2% per year continuing for 10 years will erode purchasing power by roughly 20%. But if the positive cycle of wage and price increase continues, then households will have the money to invest in other asset categories. Returns from equity and mutual funds will increase as businesses’ profitability improves, allowing for more effective asset management than during times of near-zero interest rates. Awareness of the need to protect their assets against inflation will be essential among households, and the new tax-exempt investment-account program, or NISA, would be a good place to start.

Behavior change begets sustained growth

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.
Figure 1: Flow of funds seen in net investment and savings by group
Flow of funds seen in net investment and savings by group
Source: Mitsubishi Research Institute, Inc. from Bank of Japan Flow of Funds Accounts

One example is a currently proposed policy to attract private-sector investment by the issue of Green Transformation (GX) Economic Transition Bonds with a total value of 20 trillion yen as a decarbonization initiative

Author profile


Kenta Domoto

Center for Policy and the Economy

A specialist in macroeconomic analysis such as short-term forecasts of the Japanese economy, he provides detailed commentary on economic indicators and makes economic forecasts from various perspectives using alternative data.
He provides analyses and recommendations with the goal of creating a society with hope for all.