Pax Nipponica: Inflation, Yen, and Japan's Positioning in a Fractured World

Japan, the once-dormant giant, is looming large again, as competition across the Pacific Rim intensifies. Rising wages, migration reforms, and industrial awakening – centred around advances in semiconductors, robotics, and nuclear technology – are redefining the status quo in Japan’s economy. Still, the sheepish yen continues trailing its macroeconomic comrades, leaving Japan at a key juncture. The political leadership along with the Bank of Japan’s (BoJ) forthcoming decisions, could redefine not only Japan’s recovery but also the direction of global capital flows.

When it comes to monetary policy, Japan was experimenting with the boundaries of economic orthodoxy long before esoteric monetary tools became mainstream. Milton Friedman, the prominent monetarist, was enthralled by Japan’s monetary conduct and intellectual drive. The country has been tussling with the aftermath of the flattening of its real estate and equity markets between 1986 and 1991. The legacy of that period was falling prices and a weak yen. Therefore, tools such as quantitative easing and yield control were deployed to spur economic recovery and stimulate demand.

🔹 When it comes to monetary policy, Japan was experimenting with the boundaries of economic orthodoxy long before esoteric monetary tools became mainstream. Milton Friedman, the prominent monetarist, was enthralled by Japan’s monetary conduct and intellectual drive. The country has been tussling with the aftermath of the flattening of its real estate and equity markets between 1986 and 1991. The legacy of that period was falling prices and a weak yen. Therefore, tools such as quantitative easing and yield control were deployed to spur economic recovery and stimulate demand.

🔹 Despite that trauma, Japan was able to maintain – even expand – its export-led economy. This resilience is ascribed to its genuine industrial edge and partially to a weaker yen prompted by loose monetary policy. Yet, among all the G7 countries, Japan has the highest sovereign debt, standing at 240 per cent of GDP – ergo, the systemic dependence on low interest rates. It is worth noting that around 90 per cent of this debt is domestically held, and Japan enjoys a large current account surplus – circa 208 billion dollars – with substantial cash at hand chasing returns overseas. Japan does not need bond vigilantes; it has its own shoguns.

That picture has begun to alter post the COVID era. Japan currently prints inflation at 2.7 per cent – above the Bank of Japan’s 2 per cent target. Buttressing this trend, base earnings have risen by 4.1 per cent and bonus pay by 4.1 per cent, year on year. Business sentiment too remains bullish across sectors, fuelled by solid earnings and expanding international demand. Yields on 10-year and 30-year government bonds have reached unseen highs – 1.68 per cent (from 0.85 per cent a year earlier) and 3.29 per cent (from 2.11 per cent), respectively. These shifts are reigniting domestic investment in equities and bonds, particularly among institutional investors who have long been stationed overseas.

A natural outcome of rising yields is a firmer yen: the macro landscape demands it, and any push for a lower rate policy is likely to backfire. Markets are already anticipating – if not pricing – a series of rate hikes. Yet a bolder yen may unleash some rippling effects. For years, low and negative rates have made the yen the bookies’ favourite for financing global carry trades, which borrow cheaply in yen and invest in high-yielding currencies, such as the dollar – a trade estimated at around one trillion US dollars. All of this is at risk of unwinding should the yen and bond yields continue their march upwards. Margin calls could trigger a fire sale in both the dollar and treasuries – a potential chain effect emanating from Japan’s reserved monetary conduct.

Japan is ageing – it’s hardly news: almost 29 per cent of its population is aged 65 or older. Japan acknowledges that reversing this tide is a herculean task, yet it is confronting this challenge head-on through multiple reforms. These include raising the retirement age, encouraging greater participation of women in the labour market – where only 50 per cent of them are regular employees – and better utilising its foreign workforce, who now constitute about 3 per cent of the labour force, yet still accounted for half of its growth between 2023 and 2024.

That said, the narrative around demographic pessimism often misses the line. The nation possesses a world-class ecosystem in robotics and artificial intelligence, thanks to an education system that exudes scientific excellence and creative engineering. Advances in these fields are boosting productivity and prolonging working lifespans, particularly in areas such as elder care and assisted living, logistics and warehousing, and infrastructure maintenance. Japan is culturally accustomed to robotics; thus, social acceptance eases adoption and integration – rendering a demographic challenge into a technological opportunity.

The Sino-American relationship stands at a tipping point. The US sees its hegemonic role coming under threat from China, whereas China views the US as intent on blocking its ascendancy. The relationship between the two superpowers has become confrontational – directly or through proxies – as both leverage their centrality for global trade, technology, and military power.

🔹 Japan occupies a critical position for both. Its soft power – a cultural landmark admired everywhere – and its hard power – through its well-dispersed industrial behemoths – render it an indispensable partner for the two superpowers. Japan remains the largest sovereign holder of US Treasuries, nearing 1.1 trillion US dollars, and is among the vastest importers of US gas and military hardware.

🔹 China is equally vital, if not more so, to Japan’s supply chain in electronics, machinery, and minerals. The two economies have in fact grown increasingly intertwined over the past decades through geographic proximity and economic overture aimed at mollifying tehir historically frail relationship. Not as a matter of speculation, but in his seminal Foreign Affairs essay “The Clash of Civilizations” (1993), political scientist Samuel P. Huntington prophesied that by virtue of culture, ethnicity, and security forces – which trump any shared democratic values or economic interests in his opinion – Japan might ultimately end up siding with China.

🔹 In a world laden with geopolitical tensions, reliability and quality have become paramount – and Japan excels at both. India is importing bullet trains from Japan; Australia is looking to Japan for the renewal of its frigate fleet; and even afar nations like Britain and Italy are turning to Japan’s AI and robotics industries in the development of their Global Combat Air Programme (GCAP) fighter. At a more granular level, Japan’s energy strategy has become a model for all nations massively investing in AI and data centres. The diversity of Japan’s power grid is an underrated asset – blending microreactor nuclear plants with new sources of liquefied natural gas and advanced renewables. Notably, Mr Warren Buffett of Berkshire Hathaway is among the latest worthies who have become enamoured with Japan, citing both the sophistication of its industrial base and the depth of its social fabric.

Japan’s tale is not about revival — it’s about recognition.

Despite the downbeat talk of demographics and deflation, Japan stands taller than ever. The economy exudes quiet strength; the yen is firming, fortifying the renewal narrative; and a world, weary of the US-China dichotomy, is seeking a balance. Japan has already laid the bricks of a multipolar world — industrially, technologically, and diplomatically. As the world fragments further, Japan’s ability to charm, mediate, and build may yet prove to be its most undervalued asset.