Japan’s Economy Under Strain as Monetary and Fiscal Policies Pull in Opposite Directions
Japan is entering a delicate phase as its monetary and fiscal policies move in sharply different directions, creating fresh uncertainty for markets and households already grappling with rising prices and weak growth. The growing gap between tighter financial conditions and expanding government spending is testing the country’s economic resilience and exposing divisions among policymakers over the path forward.
On the monetary side, the Bank of Japan has signaled a clear shift away from its long standing ultra loose stance. Governor Kazuo Ueda has repeatedly suggested that interest rate increases are increasingly likely as inflation remains stubbornly above target. Investors have responded by pushing up long term interest rates, with the yield on newly issued ten year Japanese government bonds briefly touching nearly two percent in mid December, the highest level seen since 2007.
At the same time, fiscal policy is moving in the opposite direction. In preliminary budget requests for the 2026 fiscal year, the Ministry of Finance allocated a record amount for servicing government debt. Spending to cover bond repayments and interest costs is set at more than thirty two trillion yen, a sharp rise from the initial allocation for the previous fiscal year. This marks the highest level on record and highlights how rising interest rates are feeding directly into public finances.
This combination of tighter monetary policy and looser fiscal policy has unsettled the government bond market. Higher yields increase borrowing costs for the state, which already carries one of the world’s largest public debt burdens. With economic growth still fragile, the risk is that Japan becomes trapped in a cycle where higher rates push up debt servicing costs, prompting more borrowing, which in turn puts further pressure on yields.
Behind this policy tension lies a broader dilemma facing the Japanese economy. Inflation has remained above the central bank’s two percent target for nearly four years, driven largely by higher prices for food and energy. In October, core consumer prices were still rising at an annual rate of three percent. These increases have weighed heavily on households, as wage growth has struggled to keep pace with the cost of living.
Currency weakness has added another layer of strain. The yen has fallen to around one hundred fifty seven to the US dollar, a level that has previously prompted official intervention. A weaker currency makes imports more expensive, further fueling inflation and squeezing consumers. Under these conditions, the central bank sees higher interest rates as an uncomfortable but necessary tool to stabilize the yen and contain imported price pressures.
Yet not all policymakers agree on the timing or scale of normalization. Some fear that moving too quickly could choke off a still uneven recovery and destabilize public finances. Others argue that delaying action risks allowing inflation expectations to become entrenched.
As these debates intensify, Japan finds itself at a crossroads. Balancing price stability, currency pressures, debt sustainability, and economic growth will require careful coordination. Without greater alignment between monetary and fiscal strategies, the country may face prolonged volatility and difficult trade offs in the years ahead.
