BUSINESS | Japan shifts beyond ultra-low rates as debt risks, $550B US pledge reshape outlook
The 2025 annual consultation on Japan said growth is expected to strengthen to 1.2% in 2025 before easing to 0.8% in 2026 as export frontloading fades and tariffs weigh on external demand.
Japan’s economy is entering a new phase of moderate growth and higher interest rates, even as public debt remains above 200% of GDP and a massive US-bound investment commitment raises fresh macro-financial questions, according to a regional surveillance report released in February 2026.
The 2025 annual consultation on Japan said growth is expected to strengthen to 1.2% in 2025 before easing to 0.8% in 2026 as export frontloading fades and tariffs weigh on external demand. The assessment, based on discussions with Japanese authorities in late 2025, noted that the economy is transitioning toward a more domestically driven model supported by private investment and consumption.
The report was prepared by the ASEAN+3 Macroeconomic Research Office, which monitors financial and macroeconomic conditions in East and Southeast Asia plus Japan, China and South Korea.
Growth firms as inflation broadens
After a slight contraction in 2024, business investment has emerged as a key driver of recovery. Private consumption has also begun to rebound on the back of higher wages despite lingering cost-of-living pressures.
Inflation momentum strengthened in 2025, supported by tight labor markets and rising inflation expectations. While headline inflation was partly driven by temporary food-related supply shocks and higher import costs, underlying pressures became more broad-based. Core-core CPI stayed above 3.0% for much of 2025, signaling a more entrenched wage-price cycle.
Rice prices were a notable outlier. Inflation in rice peaked at 101.7% in May 2025 due to extreme heat that affected yields and strong demand from tourism and households. The government responded by releasing stockpiled rice and accelerating imports, helping retail prices moderate.
The report said supply-side measures should complement monetary tightening to reduce the risk of overtightening in response to cost-push shocks.
BOJ advances gradual normalization
The Bank of Japan raised its policy rate from about 0.25% in late 2024 to around 0.75% by December 2025, signaling further gradual normalization if growth and inflation remain on track.
Balance sheet tapering continued in a measured manner. Bank of Japan holdings of Japanese government bonds declined 7.7%, from ¥589.8 trillion to ¥544.4 trillion, after quarterly reductions began in the third quarter of 2024.
In September 2025, the central bank also announced plans to sell exchange-traded funds and Japan real estate investment trusts, which together totaled about ¥37.9 trillion at the end of 2025. Sales will proceed at a modest pace to avoid market disruption.
Officials stressed that policy remains accommodative in real terms. With inflation expectations around 2% and the policy rate at 0.75%, the real policy rate remains negative, supporting a gradual transition rather than abrupt tightening.
Banking sector resilient but exposed to rate risks
The financial system has strengthened through the rate upcycle. Major banks’ consolidated profits rose 33.3% in March 2025 from a year earlier, while regional banks’ net income increased 36.6%, reflecting stronger net interest margins.
Bank lending expanded more than 3% on average in 2025, supported by demand for fixed investment, working capital and property-related financing. Nonperforming loan ratios continued to improve, and liquidity coverage ratios at megabanks ranged between 125% and 164%, well above regulatory minimums.
Still, stress tests showed sensitivity to growth and interest rate shocks. Public debt dynamics are particularly vulnerable to weaker growth and higher rates, with simulations suggesting debt could rise to nearly 217% of GDP under adverse scenarios and up to 233% if multiple shocks materialize simultaneously.
Although Japan’s gross public debt remains elevated at around 212% of GDP in baseline projections, market perception of sovereign risk has remained low, supported by a large domestic investor base and the country’s reserve currency status.
US$550B U.S. investment pledge reshapes capital flows
One of the most closely watched developments is Japan’s commitment to invest $550 billion in the United States under a September 2025 strategic framework agreement.
The memorandum of understanding calls for investments through January 2029 in sectors including semiconductors, pharmaceuticals, energy, shipbuilding and advanced technologies. Japan will receive 50% of project cash flows until its investment is recovered and 10% thereafter.
The package equals about 14% of Japan’s 2024 GDP and 24% of its outward investment position. Once completed, Japan’s U.S. investment position could grow by roughly 67%, raising concerns about concentration risk and potential crowding out of investment in ASEAN and the European Union.
Funding will involve government-linked institutions such as the Japan Bank for International Cooperation and Nippon Export and Investment Insurance. The report said a careful mix of direct U.S. dollar borrowing and reserve management will be needed to avoid excessive pressure on the yen and financial markets.
Property market stable but uneven
Housing prices have risen, particularly in metropolitan areas, but there are no significant national-level concerns about sustainability, the report said.
Price-to-income ratios remain broadly in line with the OECD average, and credit quality has not deteriorated materially. However, demographic shifts — with population growth in major cities and depopulation in regional areas — have widened regional price gaps.
Authorities were encouraged to deepen surveillance of housing risks and consider targeted, coordinated policy responses drawing on international experience.
Beyond ultra-low rates
The report’s central theme is that Japan is moving beyond ultra-low interest rates into a new chapter marked by positive inflation, firmer wages and gradual policy normalization.
To sustain growth while containing debt vulnerabilities, it recommended continued fiscal consolidation aligned with growth-enhancing reforms, structural measures to ease labor shortages and enhance productivity, and clear communication as monetary policy normalizes.
With external uncertainties still present, the transition will depend heavily on domestic demand, policy coordination and careful management of financial stability risks in a higher-rate environment.
