Economics Update December 2025 - Potential policy error in Japan

Sanae Takaichi, Japan's first female prime minister, is determined to emulate her role model Shinzo Abe in her economic and fiscal policy and revive the “Abenomics” he established. However, this could prove to be a political mistake, as the economic conditions today are very different from those in 2012, when then-Prime Minister Abe presented his economic policy strategy. 

The most important difference from the environment at that time is inflation: Abe wanted to end Japan's long period of deflationary trends through massive demand stimulation and loose monetary policy, which he only partially succeeded in doing. At the time of Takaichi's appointment, inflation in Japan stands at just under 3 percent. There is consensus that it will not fall below 2 percent in the medium term and that a relapse into deflationary dynamics is not to be feared for the time being. 

A policy that seeks to further stimulate demand in such a situation has the potential to drive up inflation and puts the Bank of Japan in an extremely difficult position. The Bank of Japan has been on a path to normalize its ultra-expansionary monetary policy for some time now. Its very cautious approach is aimed at avoiding distortions in the capital markets with regard to both interest rates and the yen exchange rate. The first point is particularly critical because normalizing monetary policy also involves reducing the central bank's purchases of government bonds. Within a year, the Bank of Japan has already reduced its purchase volume by around 10 percent, but continues to purchase government bonds worth around 12 trillion yen per quarter. 

Nevertheless, this slight reduction was enough to push yields on 10-year government bonds up to a level of around 1.8 percent. Given the enormous national debt of 235 percent of gross domestic product, this could result in potentially significant additional interest expenses for the government. This shows how limited the Bank of Japan's scope for normalizing its monetary policy is and how much it must hope that inflation does not get out of control. If the Bank of Japan were to raise its key interest rate faster than expected, negative macroeconomic consequences would be inevitable. If it failed to do so in the event of rising inflation rates, however, there would be a risk of a loss of confidence and further interest rate rises.

Takaichi must find her own economic policy

The close interlinking of fiscal and monetary policy – a hallmark of “Abenomics” – fundamentally poses a problem for the formally guaranteed independence of the central bank. This makes it all the more important that the two areas do not conflict with each other. This can only mean that fiscal policy should not be as expansionary as it was during the “Abenomics” era. Takaichi will have to find her own economic policy direction beyond her role model. Otherwise, she risks a “Liz Truss” moment if the markets start to sell off.