Stagflation Creates Policy Dilemmas, Conflict Between Takaichi and BOJ

Rising Prices, Flat GDP and Consumer Spending, Falling Real Wages

Source: Cabinet Office, Ministry of Internal Affairs and Communication

Japan has moved from deflation to “stagflation,” a state in which GDP, wages, and consumer spending are stagnant while prices soar. Stagflation is not easy to cure because the remedies for the “stag” part worsen the “flation” part, and vice versa. This dilemma has unleashed a conflict between incoming Prime Minister Sanae Takaichi, on the one hand, and the Bank of Japan (BOJ) and fiscal hawks within her own party, on the other hand.

Despite Takaichi’s claim that “Japan is back”—12 years after Shinzo Abe claimed it was already “back”—the stagflation is undeniable. Consumer prices today have risen 12% since 2021. At the same time, GDP is barely higher than it was in 2018, and when the GDP figures for July-September 2025 come out next Monday, economists believe they’ll show a drop due to Donald Trump’s trade war. One reason GDP is so flat is that real consumer spending today is slightly lower than it was 12 years ago. Spending, in turn, is so stagnant because real wages are down 7% from their 2018 level and are a bit lower than in 2012 (see the chart at the top and the one below). Higher corporate profits and stock prices don’t make Japanese voters feel they’re “back.”

The Policy Dilemma and the Diagnostic Difficulties

Here’s the dilemma. The posture necessary to reduce inflation—putting the brakes on growth via higher interest rates—worsens the stagnation. Conversely, treating stagnancy via fiscal and monetary gas pedals exacerbates inflation. Takaichi prioritizes growth, while downplaying the threat of inflation. The BOJ’s mandate is to bring inflation down to a healthy demand-driven 2%.

It would be hard enough to find the right prescription even if everyone agreed on the diagnosis, but such a consensus is lacking. There are two types of inflation, and hence two different strategies to fight it. Takaichi and the BOJ disagree about which type prevails in Japan.

One type is called “cost-push” inflation. This occurs when the economy suffers a supply shock, e.g., a price rise or even an absolute shortage, as in the Covid shutdowns. The most famous case in recent decades was the 13-fold rise in oil prices during the 1970s. The current supply shock stems from Covid and Putin’s invasion of Ukraine. Cost-push is hard to cure because the supply shock often arises from events beyond the government’s control. Even worse, if price hikes continue over several years, they can become embedded in company and consumer behavior. If so, they turn from transitory to persistent.

The other type is called “demand-pull.” This occurs when the economy becomes overheated, causing demand from consumers, companies, and the government to surpass supply. Sometimes people call it “too much purchasing power chasing too few goods.” The economy performs best when demand-pull inflation is stable at about 2% per year. That is the goal of major central banks, including the BOJ. But demand-pull inflation markedly above 2% must be avoided. That’s because, once inflation starts accelerating, that acceleration can turn into a stubborn momentum requiring a harsh recession to cure. The more excessive the boom, the tougher the bust.

Japan is experiencing both types of inflation. But the evidence is very muddy on the relative importance of each, as well as the trajectory going forward. Takaichi insists that Japan’s inflation is mostly cost-push, implies that this is a transitory problem, and contends that restoring growth is more important than suppressing this type of inflation. A year ago, she called the BOJ “stupid” for raising the overnight interest rate from zero to 0.25%. The BOJ, by contrast, asserts that the overall situation is steadily moving toward the desired 2% because inflation is switching from cost-plus to demand-pull. It projects that it will reliably reach its goal by the second half of fiscal 2027. However, it also cautions that if negative interest rates—i.e., rates below the level of inflation—are maintained for too long, it could overstimulate the economy. Demand-pull inflation could get out of control. So, it wants to gradually normalize rates to a level with a “neutral” effect on growth, while exercising some patience due to the uncertain impact of Trump’s tariffs and the fiscal policy of the new Prime Minister. Some BOJ Policy Board members are becoming impatient; two of the nine members voted to raise rates immediately at the September meeting.

The Evidence Speaks With Tangled Tongues

The evidence is so contradictory that it’s easy for players to cherry-pick the facts that fit their preconceptions. Let’s examine the data.

Households spend a third of their budget on food and energy. These are very import-intensive and thus influenced by global prices, internal supply shocks like the rice shortage, and the yen’s value. When the yen is weaker, it takes more yen to buy a barrel of oil or bushel of wheat. So, inflation in these items is mostly cost-push. Households spend the other two-thirds of their money on everything other than food and energy, and most of the inflation here is likely to be demand-pull.

Initially, it looked like food and energy inflation had peaked in late 2022. However, it has revived, in large part due to further yen depreciation. In September of this year, food and energy inflation was back to a 6% annual rate (see chart below). That’s double the 3% pace in the US and Europe.

Now, let’s look at the “core” items, excluding all food and energy. (The BOJ targets only fresh food and energy, but most central banks look at all food.) The data contradicts the BOJ’s optimism. For most of 2024-25, core inflation has been consistently below 2% and, in September, was only 1.3% (see the chart below again).

Core inflation is useful as a reasonably good predictor of the future trajectory of prices. However, consumers have to buy all items, and overall inflation has fluctuated above and below 3% over the past three years (see the chart below again).

Source: https://www.e-stat.go.jp/en/stat-search/file-download?statInfId=000032103842&fileKind=1

Another critical indicator of the role of cost-push inflation is that, in 2024-25, about 75% of the price rise was due to food and energy.

This data would appear to support part of Takaichi’s argument: that inflation is primarily a cost-push problem at present. However, it undermines her premise that this is only transitory and therefore not a concern.

However, the BOJ believes service sector inflation is a better predictor of the future. It argues that services are more labor-intensive and therefore reflect wage trends, which, for reasons I’ll discuss below, the BOJ sees as pivotal. Since services inflation has been steady at 2% since mid-2024, the BOJ views this as confirmation of its rosy assessment (see chart below).

Source: https://www.e-stat.go.jp/en/stat-search/file-download?statInfId=000032103935&fileKind=1

Nominal Wages Decelerate; Real Wages Keep Falling

The BOJ contends that, to reach its 2% inflation goal, nominal wages must rise 3% a year. Here’s its logic. If wages rise by 3% a year and output per hour grows by 1% a year, then the cost to employers per unit of their products is 2% (3% minus 1%). To maintain profits, they’ll hike prices 2%. But what if consumer demand is so weak that companies are unable to pass on the higher labor costs? The BOJ logic underplays the demand part of the picture.

In any case, employers are not steadily raising nominal wages by 3%. The BOJ and others leaped to a conclusion because wage hikes in the 2024 and 2025 shunto negotiations were so high. However, the shunto only covers 16% of the labor force. These hikes have not spread to the general workforce.

For a while in 2024 through early 2025, year-on-year wage hikes were above 3%. However, since May, year-on-year growth has consistently undershot the target and is now 2.6% (see the chart below and the accompanying note).

Source: https://www.mhlw.go.jp/english/database/db-l/monthly-labour.html Note: This chart uses a three-month moving average to smooth out fluctuations, so the last three columns cover May through September

The BOJ counters that the sample behind the chart above is not reliable since the sample of workers changes every month. It prefers a different survey that follows the same firms and workers. This survey did show wage hikes temporarily hitting 3% in late 2024. Since then, however, the pace has decelerated to just 2.2% (see chart below).

Source: https://www.mhlw.go.jp/toukei/list/30-1a.html

Even at their highest, nominal wage hikes have only rarely exceeded price hikes; that’s why real wages are falling. If inflation drops to 2%, will employers maintain higher nominal wage hikes, or will they reduce the nominal hikes so that real wages continue to fall? No one knows.

The real mystery is this: why don’t companies complaining that they can’t get enough workers offer higher pay to attract more? There are three reasons.

First of all, demand for labor is weakening. The total number of work hours for all workers in Japan never rose during the Abenomics era and has since fallen. These days, demand for labor is 3% below its 2012 level (see chart below).

Source: https://www.e-stat.go.jp/en/stat-search/database?stat_infid=000031799887&layout=dataset

The second factor is that labor has weak bargaining power for several reasons, one of which is lifetime employment. Workers have more bargaining power when they are free to switch to a company that pays more. In fact, wage suppression was a key motivation for employers to introduce the lifetime employment system in the late Meiji era (see Chapter 11 of The Contest for Japan’s Economic Future). When workers fear that leaving a company may result in a wage cut or even a demotion to non-regular status, employers have more leverage.

Finally, despite the BOJ’s confidence, many employers fear they won’t be able to pass on wage hikes to consumers.

Takaichi’s predecessors since Shinzo Abe have all called for higher wages and implemented regular minimum-wage hikes. By contrast, Takaichi says wages are something for private companies to decide. She’s not even endorsed any target for the minimum wage, such as the ¥1,500 goal espoused by Fumio Kishida and Shigeru Ishiba.

Yen Falls After Takaichi’s Ascension

One reason Takaichi opposes interest rate hikes is that she wants to help automakers and other exporters “at all costs.” Exporters want a weak yen, particularly in light of the Trump tariffs. All other things being equal, higher interest rates lure money to Japan and strengthen the yen. That, of course, means higher cost-push inflation. So, Takaichi has another incentive to discount the harm from cost-push inflation.

Since Takaichi’s ascension, the market has driven the yen down even more. When the gap between American and Japanese 10-year interest rates narrows, the yen tends to strengthen. Under Takaichi, the opposite occurred. Despite the interest rate gap narrowing to 2.4%, the lowest in three years, the yen weakened to a level more consistent with a 3.4% gap, as shown in the chart below.

Source: Author calculation based on data from Wall Street Journal

A cheap yen may please exporters and the stock market, but the resulting consequences at the grocery store will likely threaten Takaichi’s current honeymoon with the voters.

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