For three decades, Japan was the world's cautionary tale on deflation: a country trapped in falling prices, where monetary policy was powerless and inflation expectations had become permanently anchored below zero. The Bank of Japan experimented with every unconventional tool — zero interest rates, quantitative easing, yield curve control — in an effort to generate even 1% inflation. Now, finally, inflation has arrived. The question is whether Japan can sustain it, or whether its decades-long deflationary psychology will reassert itself.
What is driving Japan's inflation
The current inflation surge has three distinct drivers. First, import price inflation: yen weakness (USD/JPY around 152) is raising the cost of imported energy, food, and raw materials. Japan imports nearly all its energy and a significant share of its food — exchange rate pass-through to consumer prices is therefore unusually strong. Food prices are up 5.4% year-on-year, energy 3.1%.
Second, wage-driven services inflation: Japan's largest annual wage negotiation — the shunto — delivered average wage increases of 5.1% in spring 2026, the highest since 1991. Services firms are finally passing these costs on. Services CPI at 2.1% is historic: the last time Japan sustained services inflation above 2% was before the 1990s asset-price bubble burst. This is the domestically-generated component that the BoJ has been specifically waiting for.
Third, government subsidy withdrawal: Tokyo's energy subsidies, which had suppressed utility prices for two years, were phased out in mid-2026. Their removal mechanically added roughly 0.3–0.4 percentage points to the headline CPI rate.
The Bank of Japan's historic pivot
The BoJ raised its policy rate from −0.10% to 0.10% in March 2026 (ending negative rates), then to 0.25% in April, and to 0.50% in July — the fastest tightening pace since the 1990s. Governor Kazuo Ueda has consistently framed this as "normalisation", not tightening: the goal is to reach a neutral rate of roughly 1.0–1.5% by end-2027, assuming inflation stays on track. However, the BoJ is walking a tightrope: raising rates too fast could crash the Japanese government bond market, where the bank holds nearly half the outstanding stock from years of QE purchases.
The BoJ's October 2026 Outlook Report projects CPI staying at 2.0–2.5% through end-2027 — the first time in a generation the bank has projected sustained above-target inflation.
Structural implications: does Japan's experience generalise?
Japan's reversal has two lessons for global economics. First, inflation expectations can eventually shift even after decades of deflation — but it requires a combination of external shocks (yen depreciation, energy prices), structural wage change (the shunto), and sustained policy commitment. Second, the BoJ's experience with price-level targeting-style commitments under "yield curve control" shows both the power and limits of unconventional monetary frameworks. Japan spent trillions of yen to shift expectations; the lesson is that credibility is hard to build but easier to lose.