Economic forecast for Japan: resilient growth, inflation and BOJ policy

We forecast above-consensus GDP growth of 0.8% in 2026 and 1.0% in 2027. Higher energy prices resulting from the conflict in the Middle East are expected to weigh on household purchasing power and corporate margins, particularly in the second half of this year, while leading indicators in the manufacturing sector have started to weaken.

However, we expect the underlying growth picture to remain resilient. Recent business surveys, including the Tankan, continue to point to expanding activity. Household consumption should continue to benefit from the increase in real wages, while government measures should mitigate part of the impact of rising energy costs. Strong demand linked to investments in artificial intelligence and the resilience of business investments in capital goods should provide important support to domestic economic activity.

Looking ahead to 2027, recently announced fiscal measures, including the planned reduction in the consumption tax on food, should offer further support to families. We expect CPI inflation to rise significantly above the Bank of Japan's 2% target, with an above-consensus inflation forecast of 2.5% in 2027. This year's Shunto wage negotiations have produced basic wage increases of around 3.5%, reinforcing expectations that service sector inflation will remain strong. At the same time, the pass-through to prices of the effects of the previous depreciation of the yen, together with the increase in import and energy costs, is expected to keep goods inflation high.

While energy prices and government subsidies may temporarily reduce headline inflation, underlying inflation is becoming increasingly prevalent, and leading indicators suggest further price pressures ahead. Against this backdrop, we expect the Bank of Japan (BOJ) to continue its monetary tightening cycle. As inflation is expected to remain above the 2% target, growth is expected to remain strong and the BOJ is taking a more restrictive stance, we expect the policy rate to rise to 1.25% by the end of 2026 and 2.0% by the end of 2027. The pace of tightening is expected to be faster than expected in the previous quarter, reflecting stronger wage growth and monetary policymakers' growing concern about risks of higher-than-expected inflation. While inflation may remain above target, Japan's aging population and modest trend growth suggest that policymakers will be cautious about raising rates significantly above neutral levels.

As a result, we expect the BOJ to tolerate some overshooting of the inflation target, rather than push monetary policy decisively into restrictive territory. The recent coordinated intervention on exchange rates between the United States and Japan has strengthened expectations of further tightening by the BOJ. While intervention alone is unlikely to lead to sustained appreciation of the yen, headwinds remain in the short term, including significant demand from carry trade strategies, fiscal concerns, and investor skepticism about how far the BOJ can actually go in raising rates. However, the intervention signals a greater willingness among policymakers to address currency weakness and is accompanied by a BOJ more oriented towards restrictive policy. Together with higher policy rates, this should create a more favorable environment for the yen in the medium term.