Hope for the economy in 2025, but dangers loom

Japan enters the new year with its economy on solid, albeit unexceptional, ground.

Wages are rising and inflation is being beaten back. The government has passed a stimulus program that should help promote growth and provide some protection from inflationary pressures.

Unfortunately, even those modest achievements are vulnerable. Political uncertainty at home and a tumultuous international environment pose real risks for the nation’s economy. There is little that Japan can do about the external factors. The government of Prime Minister Shigeru Ishiba — or whoever succeeds him — must therefore do all that it can to avoid adding to the strain.

Japan’s economy is expected to grow this year. The government last month projected 1.2% growth in fiscal 2025, which starts in April, when prices are adjusted for inflation. That is slightly more than the Bank of Japan’s forecast, which expects 1.1% growth. The Organisation for Economic Co-operation and Development is more bullish: It anticipates 1.5% growth this year. Other forecasts are in that range. When the Japan Center for Economic Research, compiled predictions for this year from 37 private economists, the average was 1.11%.

All attribute the growth to expanding personal consumption — which accounts for about half of Japanese economic activity — and increasing corporate investment. The government projects the former to rise 1.3% this year, the product of wage increases and slowing inflation. Last year, large Japanese companies agreed to boost salaries by 5.1% (on average), the first increase of more than 5% in over 30 years.

The Japanese Trade Union Confederation, or Rengo, leads negotiations in annual wage talks each spring. This year, the confederation will again ask for pay hikes of 5% or more to maintain the wage growth momentum. Raises at small- and medium-size companies, which account for an estimated 70% of the workforce, have been more modest; Rengo will call for 6% hikes in those businesses.

With an unemployment rate of 2.5%, Rengo has a strong bargaining position. Japan has a structural labor shortage and tight labor markets give workers more power.

While Rengo is unlikely to get all that it demands, the most important factor is the degree to which any wage increase outpaces inflation. A once-in-a-lifetime supply chain crunch — the product of the COVID-19 pandemic and the explosion of demand when it ended — and a weakened yen pushed inflation in Japan to alarming levels.

This year, virtually all projections of inflation come in at around 2% (usually a bit over), a considerable slowdown from 2024; it hit 2.9% in November. If accurate, then wage increases of 3% are sufficient to both cover rising prices and afford a sense of well being in households.

Not surprisingly, economists now describe the Japanese economy as being in a virtuous circle, where rising wages spur consumer confidence and consumption, which in turn encourages businesses to invest more in both labor and capital.

A steady and sustainable level of inflation is the goal of the BOJ, which has spent the last several decades battling deflation. If wages and prices rise in tandem, the central bank can begin to raise its short-term interest rate, which has remained below 0.5% for the last 30 years. That, in turn, would transform currency dynamics as the gap between U.S. and Japanese interest rates narrowed. This could further strengthen Japan’s economy.

The government is trying to help. It pushed through a ¥13.9 trillion ($88 billion) stimulus package that would run through March, the end of the fiscal year, that includes subsidies to help families deal with the higher energy costs that accompany the colder weather of the first three months of the year and a one-off cash payment to low-income households.

The government is also considering a raise in the threshold for taxing income from ¥1.03 million to ¥1.78 million, which would also increase household income. This, in combination with the wage hikes, should also help boost private consumption.

Late last month, the Cabinet approved a record ¥115.5 trillion ($732 billion) budget for the fiscal year starting April 2025. That plan, a 2.6% increase from the 2024 budget, includes ¥78.4 trillion in tax receipts, a new record.

New taxes are never popular, which means that Ishiba will have to fight to secure parliamentary approval for the budget. Given his minority government, his and his Cabinet’s relative unpopularity and an Upper House election scheduled for the summer, his government’s survival could be at stake. Domestic political uncertainty would rock the economy’s prospects.

Meanwhile, Ishiba, like all Japanese politicians, businesses and economists, will be closely watching developments in the United States. The great unknown for the international economy is what President-elect Donald Trump will do once in office. He regularly speaks of his great affection for tariffs and his desire to use them to fix the U.S. economy and a host of other ailments, ranging from illegal immigration to the supply of chemicals for illicit drugs.

U.S. tariffs would invariably prompt retaliation. But Trump has brushed off concerns about trade wars, arguing that they are easy to win. He is alone in that conviction. Economists warn that a fight between the U.S. and China, the world's two largest economies, would hammer global growth.

Such tariffs would hamper Japanese exports and reduce businesses’ profits. Prices here would not rise unless the Japanese government retaliated. Nevertheless, the Japan External Trade Organization, or JETRO, estimates that global gross domestic product will decrease by 0.3% as a result of Trump’s tariffs and the impact on Japan could range from a fall of 0.12 to 0.2 percentage points.

China is battling an economic slowdown as well, one that is unrelated to U.S. policy. Not only will a weak Chinese economy undercut demand for Japanese exports, but faltering domestic demand in China will prompt its manufacturers to more eagerly explore foreign markets where they will compete with Japanese products.

Equally disruptive is the possible expansion of the conflicts in Europe or the Middle East. They would destabilize global markets by increasing prices of goods across supply chains; this has already occurred with foodstuffs in the early stages of the Ukraine war.

As ever, such looming uncertainties are the biggest threat to a sustained economic expansion. Households and businesses will respond by holding back and settling in, waiting for signs of stability before either resumes the spending that is central to a sustainable economy. The Japanese government has a limited ability to reassure either group or to compensate for foreign dislocations. It must do all that it can to ensure that it does not add to difficulties at home.