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An Outlook for the Japanese Economy

Takao Komine

This article will provide an outlook for the Japanese economy from the following three perspectives. The first one is how to view major trend changes emerging in the current state of the Japanese economy. Unless there are crucial exogenous changes, the Japanese economy will likely shift in line with past trends in terms of growth, prices, and employment without much difference. However, it should be noted that the conventional trends already indicate signs of upcoming major trend changes over the medium- to long term.

The second perspective is how to view medium-term growth potential. The so-called potential growth rate determines medium-term growth potential. Japan's potential growth rate is lower than that of other developed countries. How to understand the background of the issue and how to address it are crucial challenges.

The third perspective is how to evaluate Japan's international status. In the global GDP ranking, Japan was surpassed by Germany in 2023 to become the fourth-largest economy and by India in 2024 to become the fifth-largest. This change in Japan's international standing has occurred due to several combined causes. It is necessary to scrutinize these causes and consider how to evaluate Japan's declining international standing and respond from an economic policy perspective.

1. The Current State of the Japanese Economy and Three Major Trend Changes

First, let us review the current state of the Japanese economy. The Cabinet Office's monthly economic report (MER) on the current state of the economy states, "The Japanese economy is recovering at a moderate pace, although it remains pausing in part." Since May 2024, the MER has employed the same expression in its economic assessment. In other words, the Japanese economy is fundamentally continuing to "recover at a moderate pace." I agree with this assessment.

The reason for the expression "the economy remains pausing in part" is that nominal wage increases have not kept up with price increases; real wages are sluggish; as a result, the pace of personal consumption is weak. In this situation, the government aims to "create a virtuous cycle between prices and wages." I will return to this point later.

Next, let us take up the 2025-26 outlook for the Japanese economy. The discussion here depends on the "ESP Forecast Survey," conducted monthly by the Japan Center for Economic Research. This survey collects from about 35 eminent economists pieces of forecasts quoting concrete figures, thereby releasing a consensus (mean values). Thus, the consensus offers an average forecast by professional economists. Although we do not go into further details, this consensus forecast is known as a "good forecast" or one less susceptible to prediction errors.1 According to the latest ESP Forecast Survey (February 2025), the consensus forecast for the representative macroeconomic indicators―growth rate, inflation rate, and unemployment rate―is as follows.

The growth rate is projected to be 1.1% for FY2025 and 0.9% for FY2026. Since these figures are close to the recent trend in the growth rate of the Japanese economy, many people would consider them to be a reasonable forecast. The consumer price inflation rate (excluding perishable food) is projected to be 2.2% for FY2025 and 1.7% for FY2026. These are almost within the range of the inflation target (2%) proposed by the government and the Bank of Japan. The rate for FY2026 is projected to fall short of this target, but this will not matter because immediate calls for another monetary easing would be unlikely even if the rate dropped below 2%. The unemployment rate is projected to be 2.4% for FY2025 and FY2026. The figures represent a situation close to full employment-"everyone who wants to work is working." There is little likelihood that the rate will drop further. This is a reasonable outlook because many believe "the labor shortage will still continue."

Thus, the FY2025-2026 outlook, featuring no notable changes from the past, is quite understandable for those familiar with macroeconomic data. However, I believe that even comprehensible economic trends, while they persist, unnoticeably undergo major trend changes, that are the following three.

The first is that the supply-demand gap will continue to be in a state of near equilibrium. The supply-demand gap is an economic indicator that measures the difference between the supply capacity and demand of the entire economy; if it is negative, it indicates a shortage of demand (excess supply); if it is positive, it suggests a shortage of supply (excess demand). Demand is measurable by GDP, but the supply capacity is calculated from the so-called "growth potential." Since the computed results vary depending on estimation methods, the supply-demand gap will therefore vary depending on the estimators. Here, we will use the data on growth potential and the supply-demand gap estimated and released by the Cabinet Office. Figure 1 shows the latest supply-demand gap.

According to this estimation result, the supply-demand gap as of the July-September 2024 sector is -0.4%, almost balanced.2 The potential growth rate, according to the same estimate, is 0.5%. Since the above growth rate of about 1% predicted for FY2025-2026 exceeds the potential growth rate, the supply-demand gap will likely further approach equilibrium, and a slight supply shortage will occur.

Namely, the Japanese economy is transitioning from a demand shortage to a supply capacity shortage. This demonstrates what I mean by a significant trend change.

In times of demand shortage, voices grow louder that the government should boost demand through economic policies. The reason why the government has repeated the quasi-annual routine of deciding economic measures and expanding fiscal spending by formulating supplementary budgets is that it aims to add demand and improve the economy. From a macroeconomic perspective, I think the times of repeating "emergency economic measures" every year are over. Of course, it would be a different story if we were facing an emergency like the outbreak of the COVID-19 pandemic. Since there will be enough demand from now on, we should shift our economic policy toward increasing the supply capacity and raising growth potential. I will return to this point later.

Fig. 1: Changes in the Demand-Supply Gap

Source: Cabinet Office website. As of December 18, 2024.

Secondly, as for prices, it is highly significant that the consumer price inflation rate will continuously remain at around 2%. If prices continue to rise, wages and interest rates will also rise. If income increases and the deflator rises, nominal GDP will also increase. Figure 2 compares, in terms of prices, wages, interest rates, and nominal growth rates, the annual average values in FY2010-2020 before the price hikes with those for FY2024-2026. The Figure shows that all of these values, which were below 1% before the price hikes, have shifted to a level of 1-3% since FY2024. As nominal values turn positive, the impact will affect various sectors.

The "exit from deflation" is no longer a policy goal. The government defines the "exit from deflation" as "that prices have escaped from a situation of sustained decline and are unlikely to return to such a situation again."3 In short, the exit from deflation as a policy goal means aiming to "create a situation in which prices will not fall." However, inflation has been above 2% for about three years; the people complain of being bothered by price hikes. In such a situation, a policy of "preventing prices from falling (ensuring price increases)" is quite strange.

Upon further consideration, the government's policy of aiming for a "virtuous cycle between prices and wages" will not make much sense in a post-deflation economy. The phrase "virtuous cycle between prices and wages" may make many people think of a cycle of "price increases" → "wage increases" → "price increases due to increases in wage costs" → "further wage increases." However, in this cycle, prices rise in the same proportion as wage costs rise; therefore, real wages do not rise, and people's livelihoods do not improve. This cycle is meaningful only for situations where the policy goal is to "sustain price increases." Indisputably, if "wage increases exceeding price increases" were to be realized, people's livelihoods would improve; yet, this would not be realized by price transfer but could only by increasing value-added productivity. To this end, we must increase the growth rate of the Japanese economy as a whole.

We also need to adopt a different approach to finances from before. If the Japanese economy overcomes deflation and the rate of price/income increases rises, there will be both positive and negative effects on finances. The positive effect is that tax revenue will increase as nominal income increases, while the negative effect is that government bond costs will increase as interest rates rise. However, there is a difference in the time lag between these positive and negative effects. In short, the effect of income and tax-revenue hikes are tangible without any time lag. Meanwhile, there is a long time lag for the effect of interest rate hikes because most government bond debt carries no interest, and government bond costs will increase as the government bonds are refinanced gradually.

Owing to this difference in time lag, Japan's fiscal management will be relieved for the time being. The FY2025 budget has become the largest one in history, with expenditures increasing by 3 trillion yen. On the other hand, since tax revenues will increase by 8.8 trillion yen, the fiscal situation will improve considerably. Notwithstanding this, if the government lessens its vigilance, increases in government bond costs will have a gradual adverse effect in due course, making fiscal operations difficult. The government is required to cope with demanding fiscal operations.

Fig. 2: Prices, Wages, Interest Rates, and Nominal Growth Rates Turning Positive
FY2010-2020 Annual Average FY2024 FY2025 (Forecast) FY2026 (Forecast)
Consumer Price Inflation Rate 0.6% 2.6% 2.2% 1.7%
Nominal Wage Increase Rate 0.1% 3.2% 2.7% 2.5%
Long-Term Interest Rate (10-year government bond) 0.39% 1.05% 1.37% 1.55%
Nominal GDP Growth Rate 0.8% 3.2% 3.0% 2.4%

Source: Based on the Prime Minister's Office "Consumer Price Survey," the Cabinet Office's "National Economic Accounts," the Japan Center for Economic Research's "ESP Forecast Survey (February 2025)," etc.

Thirdly, the unemployment rate also indicates an important point: If the full-employment situation continues, the labor shortage will worsen. Here, we must consider the likelihood that the Japanese economy will face the "second Lewisian Turning Point" in the near future.

The idea of ​​the Lewisian Turning Point stems from the economic development theory. In a country that enters the path of economic development, the economy initially grows as surplus labor in low-productivity rural areas flows into the highly productive industrial sector in cities. Japan's period of high economic growth is a representative case of this process. However, when the surplus labor is exhausted, this mechanism no longer functions, and the development dependent on low wages is compelled to change its course. This is the Lewisian Turning Point. The first Lewisian Turning Point came to Japan in the 1970s.

Japan is now approaching the second Lewisian Turning Point. I will return to this topic when considering future growth potential.

2. Medium-Term Outlook for the Japanese Economy

Next, let us look at the Japanese economy from a slightly longer time scale. The "ESP Forecast Survey" examines the medium-term economic outlook as well. According to the Survey conducted in December 2024, Japan's average real growth rate is estimated to be 0.8% for FY2026-2030 and 0.6% for FY2031-2035, which are roughly the same as the current growth rate for FY2025-2026, slightly lower, though. The average consumer price inflation rate (excluding perishable food) is projected to be 1.7% for FY2026-2030 and 1.6% for FY2031-2035, which are also the same as FY2025-2026, slightly lower, though. Although the recent Survey failed to examine the unemployment rate, it is apparent that full employment will continue at a 2% level. Many economists predict that an economic growth of 0.5-1%, an inflation of 1.5-2%, and an unemployment rate in the low 2% range will continue over the medium term.

Although many Japanese may say that there are no problems with prices and the unemployment rate, they think the growth rate should increase a little further. The present issue is that Japan's potential growth rate is low on an international scale. According to the Cabinet Office's "Monthly Economic Report's Attachment (December 2024)," the potential growth rates of major developed countries are 2.3% for the United States, 2.1% for Canada, 1.4% for France, 0.8% for Germany, and 0.5% for Japan, the lowest among them.

Why then is Japan's potential growth rate so low? Figure 3 compares the potential growth rates for 1995 and 2024 (the 1st-to-3rd quarter average) by its components. Here, the country's potential growth rate is obtained as the sum of four production factors: total factor productivity, capital, working hours, and the number of workers. "Capital" refers to the amount of capital stock generated by, among other things, corporate capital investment. "Working hours" denotes the total working hours of all employees, while the "number of workers" indicates the total number of employees. The more these increase, the higher the potential growth rate. Total factor productivity is the residual hard to explain by the input of these production factors and is generally considered technological progress.

As this table indicates, Japan's potential growth rate was 1.6% in 1995; it declined by 1.2% to 0.4% in 2024. The bottom row of the table shows which production factors contribute to the decline of the potential growth rate. One may casually think that "Japan's population is decreasing. So, the declining number of workers must be contributing most to this." However, the factors that have a more negative contribution than the number of workers are capital and total factor productivity.

Fig. 3: Factors Contributing to Japan's Declining Potential Growth
Potential Growth Rate Total Factor Productivity Capital Working Hours Number of Workers
1995 1.6% 0.9% 0.9% -0.5% 0.3%
2024 (1-3 quart. average 0.4% 0.5% 0.1% -0.4% 0.1%
Change -1.2% -0.4% -0.8% +0.1% -0.2%

Source: Cabinet Office website

This is understood as a result of insufficient capital investment by companies and a low contribution of technological progress dependent on capital investment. In recent years, Japanese companies have been storing much of their profits as cash deposits; they are reluctant to expand capital investment for future business development. Looking at the ratios of cash deposits held by companies to nominal GDP (2023), 60.2% for Japan, which is significantly higher than 17.1% for the United States, 20.3% for Germany, 28.5% for the United Kingdom, and 32.8% for France.4 It is not easy to increase private companies' capital investment by policy measures; the only way to improve the investment environment for businesses will be through addressing concerns about the fiscal deficit, ensuring the sustainability of the social security system, and creating a conducive environment for start-up companies.

The number of workers, which has been a minor negative contributor so far, is likely to become a significant growth constraint. As mentioned above, Japan is about to reach the second Lewisian Turning Point. The demographic shift is related to this. Let us compare the demographic situation between 2013 and 2023. During this period, the total Japanese population decreased by 3.06 million, and the working-age population (15-64 old)―the source of the labor force―decreased by 5.06 million. Meanwhile, the number of employed people increased by 4.21 million, mainly due to the increase of elderly workers and non-regular female employees. The number of non-regular female employees increased by 1.43 million, while that of elderly non-regular male employees increased by 940,000. Yet, this will not continue for long. Eventually, the available reserves of non-working women and elderly people will run out. Figure 4 shows a medium-term labor force outlook according to the medium-term forecast by the Japan Center for Economic Research. This outlook illustrates that the labor force will peak in 2025-26 and then begin to decline. This peak is nothing other than the second Lewisian Turning Point.

After crossing the second Lewisian Turning Point, the Japanese economy would have to undergo structural reforms on various fronts. The times in which companies choose employees will end, and people will choose companies. As the labor force will become scarcer, wages will naturally rise. Companies could not survive unless they maintain value-added productivity commensurate with higher wages they pay.

Fig. 4: A Medium-Term Labor Force Outlook

Source: Japan Center for Economic Research, "51st Medium-Term Economic Forecast (FY2024-2035)" (December 2024)

There is no magic formula for raising the potential growth rate. All we can do is deal with such challenges from a long-term perspective such as advancing technological development, raising total factor productivity by promoting R&D efforts, improving the environment for capital investment, increasing labor mobility, cultivating human resources, and eliminating mismatches.

3. What Should We Think About the Changing International Status of the Japanese Economy?

Lastly, let us think about the changing international status of the Japanese economy. In 2023, Germany's GDP surpassed Japan's. According to the IMF's forecast, India's GDP will overtake Japan's in 2024. For more than 40 years since the late 1960s, Japan's GDP has been the second world largest after the United States, but in 2010, it was surpassed by China and fell to the third place. It has now dropped to the fourth then to the fifth place (See Figure 5).

First, let us consider the background of the reversal of the GDP ranking of Japan and Germany. The primary factor was the depreciation of the yen. Japan's nominal GDP increased by 7.5% from 550.5 trillion yen in 2012 to 591.9 trillion yen in 2023. However, the same nominal GDP values in the US dollar term decreased by 39% from 6.9 trillion dollars in 2012 to 4.2 trillion dollars in 2023 because the yen's rate to the dollar fell by 43% from 79.8 yen to 140.5 yen during this period. Without this phenomenal fall in the yen rate, the reversal of the GDP ranking of Japan and Germany would not have taken place.

The sluggish Japanese economy also played a role in the reversal. Comparing the GDP growth rates of Japan and Germany between 2000 and 2023, the real GDP growth rate is 0.7% for Japan and 1.1% for Germany; the nominal growth rate in each country's domestic currency is 0.5% for Japan and 2.9% for Germany. Germany's nominal GDP almost doubled, while Japan's increased only by 13%. This difference in the two countries' long-term growth rates contributed to the reversal of their GDP ranking.

Fig. 5

Source: International Monetary Fund, World Economic Outlook Database (April 2024)

Next, let us consider a GDP comparison between Japan and India. The comparison is related to the difference in the two counties' population sizes. GDP size is the product of "population" and "GDP per capita." Consequently, it is a truism that the GDP size of China exceeds that of Japan. As of 2023, China's population is 1.43 billion, more than 10 times that of Japan (120 million). This means that if China's GDP per capita increases by just one-tenth of Japan's, its economy will be larger than Japan's. The same is true for India. Since India's population as of 2023 is 1.43 billion, it is no wonder that its economy will eventually surpass Japan's.

From the above, it is apparent that Japan's declining international status in terms of GDP size can be accounted for by the combined effects of short-term exchange rate factors, medium-term growth factors, and long-term population factors. The question is how to evaluate the implications of Japan's declining international status. Of these three factors, the population factors are beyond our control; the exchange rate factors fluctuate widely in the short term and are hard to handle by policy measures. Then, manageable are growth factors alone; consequently, the policy challenge before us is to raise the growth rate as high as possible.

Raising the long-term growth rate as high as possible and sustainably means nothing other than increasing the potential growth rate. This is the most basic of the basic economic policies to improve the well-being of the entire nation. I feel ill at ease with the idea that Japan's declining international status matters most, suggesting that we should strive for higher economic growth to maintain this status. My view is: "It is a self-evident goal for the government to aim for high economic growth as an economic policy for the people; how Japan's international status will change is a consequence of strenuous efforts."

(Visiting Professor, Taisho University)

(Translation by Tsutomu Inuzuka)

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