Japan

Real GDP is projected to grow by 1.3% in 2023 and 1.1% in 2024, mainly driven by domestic demand. Government support to help households cope with the energy price shock and increased defence spending will boost consumption and investment. Core inflation (excluding energy and food) will increase towards 2% as wage growth gains momentum and spreads to SMEs in 2024. The labour market will remain tight, with the unemployment rate edging down to 2.4% in 2024.

Given limited fiscal space, and the need to foster lower energy use, energy subsidies should become more targeted, with a view to eventually phasing them out. Additional structural spending and revenue measures are needed, especially given the fiscal pressures from an ageing population. A credible fiscal framework is also required to put the debt-to-GDP ratio on a clear downward path. Further modifications to the conduct of yield curve control can increase flexibility and lower the risks of abrupt changes later. The Bank of Japan should communicate its current and future monetary stance clearly and in a timely manner. Policies to boost productivity and reduce the gender wage gap are needed to improve well-being and medium-term fiscal sustainability.

Real GDP grew by 0.4% q-o-q in the first quarter of 2023, driven by strong internal demand. After peaking at 4.3% in January, headline consumer price inflation fell to 3.5% in April, partly due to the introduction of new subsidies to electricity and city gas bills. Despite a high job opening-to-applicant ratio and low unemployment, nominal wages were up by only 1.3% in March over a year earlier. However, the tentatively agreed increases of 2.1% in base pay and 3.7% in headline wages in this year’s Shunto wage negotiations foreshadow greater wage momentum. Despite high inflation weighing on real disposable incomes, consumer confidence has risen and household consumption, especially in service sectors, has been growing steadily, reflecting the restoration of socio-economic activities. Following the opening of borders in October 2022, the Japanese government has classified COVID-19 in the same category as normal influenza from May 8, which will continue to support domestic demand.

A weaker global economy has slowed external demand growth, despite an easing of supply chain disruptions. The Bank of Japan’s latest Tankan survey showed a divergence in business confidence between manufacturing, which continued to decline, and the non-manufacturing sector. While commodity prices have been decreasing and the slowdown in global monetary tightening has moderated the yen’s depreciation, the trade deficit remains large. The number of inbound tourists has been recovering, but remains well below 2019 levels, partly due to the delayed return of Chinese tourists, who accounted for one quarter of total visitors in 2019. Adding to current price subsidies, a decrease in the renewables levy introduced in April has mitigated the energy shock further. However, the impact of these measures on prices is likely to be partly reversed from June, as seven major electricity companies increase their prices.

Following the October 2022 economic package, which includes measures to moderate energy and food prices (JPY 6.3 trillion, 1.2% of GDP), the government implemented further measures in March 2023 (JPY 2.2 trillion, 0.4% of GDP), financed by the contingency reserve fund from FY2022. The measures include one-off cash benefits to low-income households with children and a grant to local governments to protect households and local firms against high energy costs. The OECD projections assume the price subsidies to electricity and city gas will remain in place after September, the current official expiry date, but gradually decline over time. In 2024, fiscal support is projected to be scaled back with the end of pandemic-related measures and the gradual decline in energy price support. On the other hand, the annual defence budget will gradually increase from JPY 5.4 trillion in FY2022 to around JPY 9 trillion by FY2027 based on a new five-year plan announced in December 2022. The gross public debt-to-GDP ratio is projected to remain high at close to 247% in 2024.

While consumer price inflation excluding fresh foods, which is the measure the Bank of Japan uses to guide its monetary policy, has exceeded the 2% target since April 2022, the Bank recently announced that there will be no change in its monetary policy framework and stance. In line with the OECD baseline projections for inflation and wages, continued policy accommodation is projected through 2024. However, to safeguard financial stability and market functioning, the Bank is assumed to further modify the conduct of yield curve control, following the widening of the 10-year bond yield fluctuation band around zero from around +/- 25 basis points to around +/- 50 basis points in December 2022. Such a move would increase flexibility and lower the risks of abrupt future changes and should be accompanied by timely and clear communication of the current and future monetary policy stance.

GDP growth is projected at 1.3% in 2023 and 1.1% in 2024, driven by domestic demand. Private consumption will be supported by savings accumulated during the pandemic and government measures, despite weak real disposable income growth. Government subsidies, especially for green and digital investment, will raise business investment, despite higher uncertainty. Headline consumer price inflation is projected to peak in the third quarter of 2023 due to higher food and electricity prices. Despite the agreement for stronger wage growth in larger companies, the impact on aggregate wages will be lagged and smaller because SMEs, which are still negotiating wage agreements, will only partly follow suit. As wage growth gains momentum, core inflation will gradually increase and approach 2% in the latter half of 2024. The labour market will remain tight, and the unemployment rate will edge down to 2.4% in 2024.

Downside risks include weaker-than-expected external demand and renewed supply chain disruptions, as well as a potential abrupt change in monetary and financial conditions. In the context of the high level of public debt, a loss of confidence in Japan’s fiscal sustainability could destabilise the financial sector and the real economy, with large negative spillovers to the world economy. In contrast, growth could be stronger in the event of a faster-than-expected recovery of consumption, especially of services. It would also be boosted by stronger-than-expected external demand, including inbound tourism, related to the re-opening of China.

The expected decline in the labour force due to a shrinking and ageing population makes productivity gains essential to support well-being and fiscal sustainability. Enhancing labour market flexibility, improving insolvency procedures by increasing the wealth exemption from personal bankruptcy, and lowering barriers to foreign direct investment would strengthen business dynamism. The productivity gap between large firms and SMEs should be addressed by improving the targeting of R&D spending and supporting SMEs’ ability to adopt digital technologies. Greater use of digital technologies can also improve fiscal sustainability by increasing the efficiency of health and long-term care spending. On the other hand, higher structural government expenditures without additional revenues would worsen fiscal sustainability and threaten sustainable growth. Fiscal consolidation efforts should resume on both the expenditure and the revenue side, including social security and tax system reforms, and improved spending efficiency, with a feasible target. Enhancing energy security and lowering dependence on fossil fuels requires stepping up the promotion of research, development, and deployment of green technologies, rolling out renewable energy and encouraging greater energy efficiency. Continuing Work Style reforms, including equal pay for equal work and flexible work arrangements, and improving child-care provision would promote female employment and reduce Japan’s large gender wage gap. In the context of labour shortages, especially in ICT, reforming STEM curricula to make them more attractive to study and promoting greater female participation in these fields, such as through mentor programmes, are also key.

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