Summer ends, prices rise: Japan’s uptick in inflation

With subsidies expiring, core prices climbing, and the Bank of Japan hesitating to tighten rates, investors must now navigate an economy where both policy and price dynamics are shifting all at once.

Japan has, since the COVID-19 pandemic, basked in the world of rising prices after decades of deflationary pressures. Yet the country’s inflation dynamics recently shifted as the summer months came to an end, revealing an interplay between seasonality and policy intervention amidst external shocks.

After the expiration of the Ishiba administration’s summer energy subsidy worth JPY 288 billion (USD 1.85 billion) that had temporarily lowered electricity and gas bills, household utility costs spiked sharply. Combined with persistent food-price pressures, headline inflation returned to 3 per cent in October, reversing the months-long deceleration that had offered households some relief. Additionally, core inflation – which excludes the ever-fluctuating fresh food and energy costs – rose slightly above headline inflation by 0.1 percentage point, indicating that the recent uptick is not limited to volatile components but reflects a broader source of price pressures.

The pattern is visible in Graph 1, which illustrates that core inflation increased steadily between mid-2024 and mid-2025. Halfway through this period, it flattened and declined between July to September 2025, coinciding directly with the government’s summer electricity and gas subsidy to households. While it helped cool down heads from the summer heat, inflation resumed climbing almost immediately after the season, showing that underlying cost pressures had merely been shrouded, not resolved.

A spooked BOJ

Conventional macroeconomic wisdom suggests that interest rate adjustments are primary tools for stabilizing inflation. Yet Graph 1 demonstrates that fiscal intervention can temporarily throw off the pace of inflation, though not durably enough to push price movements towards the Bank of Japan’s (BOJ) 2 per cent inflation target.

Faced with rising living costs and slumping household sentiment, the new Takaichi administration has embarked on the Japanese government’s most ambitious fiscal package since 2020. In a newly approved stimulus package worth over JPY 21.3 trillion (USD 136.7 billion), the state aims to provide electricity and gas subsidies, cash transfers to households with children, and other reliefs such as the abolition of the current provisional JPY 25.10 (USD 0.16) per litre gas tax, despite an estimated revenue loss of JPY 1.5 trillion (USD 9.6 billion).

Energy support alone will provide over JPY 3,000 (USD 19.26) per household from January through March 2026. The government brands this as “wise spending”, aimed at stimulating consumer spending while directing investment towards sectors essential for national security, which include artificial intelligence, shipbuilding, semiconductors, and diplomacy.

While good on the surface especially in managing energy costs borne by households, the stimulus program is not without risks. It may even have the reverse effect of further increasing inflationary pressures. For instance, the yen has weakened while the benchmark 10-year Japanese government bond yields have climbed, indicating nervous markets despite the attempt to soften inflation. Investors recognize that larger fiscal deficits will require increased bond issuance as inflation becomes higher, which is bad for a country like Japan with a debt-to-GDP ratio of over 230 per cent. As Graph 2 shows, the yen’s depreciation has failed to suppress yields; instead, the yield curve has continued to steepen since Takaichi took office.

Despite rising core inflation through most of 2025, the BOJ only raised the short-term policy rate to 0.75 per cent in December, signalling extreme caution amid a weakening export performance. Previously, the BOJ’s interest rate hike in July 2024 was followed by a stock market dip due to unwinding yen carry trades. This time, equities fell ahead and followed the announcement of the fiscal stimulus, indicating that investors view the government’s expansionary stance as the bigger source of economic risk.

Spending pressures

Japan’s exports remain generally stronger than expected but faces some dips on US-bound exports due to the effect of higher tariffs. Thus, the BOJ still expects another wave of wage hikes early next year. This is crucial as without sustained wage momentum, Japan risks slipping back into the pattern where inflation rises faster than incomes, further eroding real purchasing power as inflation deviates further from the Bank’s target range.

Meanwhile, the November consumer confidence index showed an increase of 1.7 points from October. This is largely driven by a 1.9-point improvement in consumers’ confidence in overall livelihood. However, optimism remains below pre-COVID levels. In terms of price expectations, about 90.6 per cent of households are betting on prices rising faster, suggesting that anticipation for inflation remain on the high side. Under these conditions, households may reduce spending or defer major investment plans until they perceive that price stability has returned. This casts another doubt on the potential impact of Takaichi’s hope for a demand-led growth. While upcoming subsidies may ease the pain in the near term, the structural burden of inflation may persist.

A new era for Japanese macro policy?

Clearly, Japan is entering a transitional phase in its macroeconomy. The BOJ and market participants have operated under low interest rates, weak demand, and subdued prices growth assumption for years. This is now changing.

The current combination of ambitious fiscal expansion, broad-based inflation and a cautious central bank seems to be redefining the country’s policy normalisation path. Whether this becomes a transition to a higher inflation, higher-rate Japan or just a brief episode of price volatility depends on how well Takaichi’s fiscal discipline intertwines with the BOJ independence, wage dynamics, and external shocks in the coming year.

For investors, the stakes are rising. The era of deflation seems to be over, but Japan must now smoothen this shift while balancing political priorities with macroeconomic credibility.