The Organization for Economic Co-operation and Development (OECD) stated in its latest economic survey of Japan released Wednesday that the Bank of Japan's short-term policy rate is expected to gradually rise from the current 0.75% to 2% by the end of 2027, supported by robust domestic demand that is helping the economy withstand external shocks. This assessment is more aggressive than the International Monetary Fund's and the market's general expectation for a terminal rate around 1.5%, highlighting the OECD's optimistic view that Japan's economy is emerging from decades of deflation.
The OECD report notes that Japan's economy is in a critical transition phase, moving from a "near-zero inflation" pattern that lasted thirty years to a new stage driven by domestic demand, characterized by coordinated growth in prices and wages. The report argues that further interest rate hikes are justified as underlying inflationary pressures have solidified. Data indicates that inflation was initially driven by rising external commodity prices, but persistent labor shortages are now continuously pushing up nominal wages, creating a more stable endogenous momentum. The OECD expects the inflation rate to gradually approach the Bank of Japan's 2% target between 2026 and 2027. Based on higher inflation expectations, solid wage growth, and a closed output gap, the Bank of Japan should continue to raise rates cautiously. While external uncertainties from geopolitical risks such as the Middle East conflict require vigilance, the OECD believes the Japanese economy has shown sufficient resilience. The report forecasts that after growing 1.2% last year, Japan's economy will expand by 0.7% in 2026 and 0.9% in 2027.
Regarding the endpoint of the rate hike cycle, the OECD's calculations align with the Bank of Japan's internal research. The central bank's latest estimates suggest Japan's real natural interest rate is between -0.9% and +0.5%. If inflation remains at 2%, the nominal neutral rate would range from 1.1% to 2.5%. The OECD points out that the current policy rate of 0.75% is still near the bottom of the nominal neutral rate range, making a gradual increase to 2% by the end of 2027 a reasonable path.
On quantitative tightening, the OECD welcomes the Bank of Japan's approach of gradually reducing its purchases of Japanese government bonds, stating it improves market functioning. However, it also warns of risks, noting that due to years of low interest rates, the share of government bonds held by banks, insurance companies, and pension funds has declined. The report recommends that the Bank of Japan should be prepared to flexibly adjust the pace and maturity structure of its bond purchases if market turbulence occurs. The central bank is set to review its current balance sheet reduction plan at its policy meeting on June 15-16 and formulate a new plan for after April 2027.
On fiscal policy, the OECD's recommendations contrast sharply with the domestic political climate in Japan. The report urges the Japanese government to primarily rely on raising the consumption tax to increase fiscal revenue, stating that the current 10% rate is relatively low among OECD members and that a tax increase would have a relatively limited negative impact on long-term economic growth. Facing expectations of an aging population, rising debt servicing costs, and increased defense spending, the OECD emphasizes Japan's urgent need to build fiscal buffers. The report explicitly states that, rather than implementing broad tax cuts such as temporary reductions in food taxes—an approach being considered by Prime Minister Hayashi—to address rising living costs, a more targeted approach to support sustained real wage growth would be preferable. The OECD sharply criticizes broad tax cuts as costly, poorly targeted, and ineffective.
The report also highlights Japan's deep-seated structural challenge: a severe and growing labor shortage. To address this, the OECD calls for increasing labor force participation rates among women, older people, and foreign workers. It specifically notes that the government should invest more resources to help foreign workers integrate into local communities, especially in rural areas with less experience in hosting them. However, this recommendation touches on a politically sensitive issue in Japan today. With rising nationalist sentiment, immigration has become a contentious topic, boosting support for Prime Minister Hayashi and her right-wing party. Although the number of foreign workers in Japan reached a record high last year, it remains low compared to other developed economies.
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