Japan’s economy is renormalizing after decades of flirting with deflation

Stronger growth combined with higher inflation suggest that Japan’s economy is renormalizing after decades of flirting with deflation. Stronger wage growth is expected to usher in more consumer spending, which will help keep the economy from falling back toward deflation. Still, elevated commodity prices remain a clear challenge to this renormalization process. In addition, headwinds from the rest of the world are gaining pace.

Renormalization is still a work in progress

At first glance, it appears that Japan has entered a highly inflationary period. Headline inflation was 3.6% on a year-ago basis in March. Core inflation, which excludes fresh food, was up 3.2% over the same period. Core-core inflation, which excludes both fresh food and energy prices, accelerated to 2.8% in March, up from 2% the previous September. From this perspective, it would appear that the days of worrying about deflation are long gone.

Unfortunately, that is likely untrue. Food and energy prices are still driving much of the inflationary environment in Japan. Fresh food, all other food items, and energy were all up more than 5% on a year-ago basis in March, with fresh food prices rising 13.8%. Western core inflation, which excludes all food, nonalcoholic beverage, and energy prices, was up only 1.6% from a year ago. Excluding February 2024, that was the lowest reading since December 2022. Similarly, services inflation, which depends more on demand-side factors, decelerated to 1.4% in March. The latter two readings provide a better glimpse of what underlying inflation really looks like.

The main challenge Japan’s economy faces is that prices are rising too quickly for nondiscretionary items. Food and energy prices are the main culprit, making it difficult for households to increase their spending elsewhere in the economy. Even with the near-record wage increases seen last year, workers are still feeling strained by the rise in the cost of living. For example, real total cash earnings for workers, which are adjusted for inflation, fell 1.2% on a year-ago basis in February. After excluding volatile bonus payments, real contractual earnings were still down 2.5%.

Some of the weak wage growth is due to base effects. There was a huge spike in wages last January, which flattered wage growth throughout 2024. There was always likely to be a downward correction in growth at the start of this year, ahead of the spring wage negotiations between labor s and employers, also known as shunto. In nominal terms, contractual wages were up a moderate 1.7%. That just wasn’t enough to overcome the strong headline inflation seen at the start of the year.

Fortunately, the spring wage hike announcements, as of this writing, appear to be modestly stronger than the wage hikes workers received last year. For example, the Japanese Trade Union Confederation announced that its member s would secure wage increases of 5.5% on average this year, up from 5.1% announced last year. In addition, the government is attempting to accelerate the pace of minimum wage increases to provide more support to households. Prime Minister Shigeru Ishiba wants to raise the hourly minimum wage from 1,055 yen to 1,500 yen over the course of five years—this would require a 7% increase in the minimum wage annually.

Against this backdrop, many consumers are understandably tentative. Still, consumer spending has improved modestly even after adjusting for inflation. For example, the real consumption activity index was up 1.3% from a year earlier in February. Although still fairly modest, that is a clear improvement from the 0.1% average growth in 2024.

Consumer spending may pick up relatively soon as people regain purchasing power from easing inflation. There has already been a slight moderation in food and energy prices. Fresh food prices eased from 22% year over year in January to 13.8% in March. Similarly, energy prices went from 10.8% year-over-year growth in January to 6.6% in March. The one area where there has been no evidence of moderation is in rice prices, which accelerated from 70.8% in January to 92% in March. However, the government auctioned 142,000 tons of its rice stockpile between March 10 and 12, which could alleviate rice price pressures soon.

A stronger yen would also help ease price pressures of imported commodities such as food and energy. The yen has strengthened this year, going from 157.8 against the US dollar to 142.76 the week ending April 18. The appreciation of the currency is partly due to weaker sentiment in the United States market. US bond traders expect the Fed to cut rates more aggressively to support the economy as higher tariffs in the United States restrain growth. This has led to weakness in the US dollar compared to numerous currencies including the yen.

At the same time, the Bank of Japan will likely continue to raise rates this year, although modestly. This should provide additional strength to the yen. However, the central bank has remained relatively cautious in raising interest rates, holding rates at 0.5% in March, a relatively accommodative stance compared to 3.6% inflation. Some of that caution is due to the potential headwinds coming from US trade policy, while some of it is also likely due to the desire to prevent the economy from backsliding into deflation.

Exporters face a rough road ahead

Japan’s export growth will likely come under pressure this year. Net exports of goods and services contributed a sizable 0.7 percentage points to real GDP growth in the last quarter of 2024. Exports continued to accelerate at the start of this year. Goods exports were up 8.6% from a year earlier in the first quarter of 2025. Exports to the United States and Asia were the principal drivers of those gains. At least some of the recent surge in goods exports appears to be related to frontloading of shipments ahead of tariffs in the United States.

As tariffs continue to rise in the United States, we will likely see a retrenchment of exports. The United States, which was Japan’s largest goods export market in 2024, announced that it would place 25% tariffs on finished autos on April 2. Another 25% tariff on select auto parts is expected to go in place May 3. This is a serious headwind for Japanese auto manufacturers. Japan exported 7.3 trillion yen (roughly US$48 billion) worth of motor vehicles and parts to the United States last year (figure 2). That is just over a third of all goods exports to the United States and just under a third of all motor vehicle and parts exports from Japan.

In addition to the tariffs on vehicles and auto parts, the United States announced that it would implement a 24% tariff on its imports from Japan. Early reporting of such measures indicated that these additional duties were to offset Japan’s nontariff barriers. However, according to the World Trade Organization, Japan actually has fewer nontariff measures than the United States. This, along with low tariffs, likely complicate Japan’s ability to negotiate lower tariffs for its products. Japan and the United States are negotiating a trade deal but had yet to reach agreement as of this writing.

In addition to headwinds from the United States, Japanese exporters continue to face headwinds from China, Japan’s second largest goods export market in 2024. China’s economy continues to struggle after the property sector bubble began to collapse in 2022. China has increasingly used its trade balance to fuel growth, forcing exports higher and imports lower. Japan’s exports to China, when valued in yen, were up just 0.7% from a year earlier in the first quarter of 2025. Without a material pickup of Chinese domestic demand, Japanese exports to its second largest market will likely remain muted at best.

Japan’s domestic economy continues to make progress even if its gains remain relatively subdued. A tight labor market has kept nominal wage growth relatively strong. The main impediment to stronger consumer spending is rapidly rising commodity prices. Once those prices come back down, households should be able to spend more in volume terms. However, commodity price normalization may not be quick. In addition, tariffs in the United States and weakening growth in China raise serious concerns for Japanese exporters just as the yen is appreciating and making their goods less competitive.