Real GDP is projected to rebound by 1.5% in 2025, driven by domestic demand, with growth reverting towards potential in 2026, at 0.6%. Private consumption will be driven by robust wage growth, moderating headline consumer price inflation, and recent government support measures. Large profit gains, partly due to the weak yen, and government subsidies, especially for green and digital investment, will boost business investment. Headline inflation is projected to settle around the 2% target, supported by wage growth momentum and the pass-through of labour costs to prices.

The fiscal stance is projected to be slightly expansionary in 2025, with the recent economic stimulus package, before tightening in 2026, and the primary balance is set to remain negative. Designing and implementing a medium-term fiscal consolidation path, with concrete revenue and expenditure measures, including social security and tax reforms, is needed to secure medium-term fiscal sustainability. The use of supplementary budgets should be limited to large macroeconomic shocks. Projections of sustained inflation around the 2% target and robust wage growth imply gradual increases in the policy interest rate are warranted. Structural reforms to boost productivity, employment, especially of older and female workers, and the integration of foreign workers, are key to address labour shortages and demographic headwinds.

Real GDP grew by 0.2% in the third quarter of 2024, supported by robust private consumption. Reflecting the outcome of the annual wage negotiations for FY2024 and summer bonuses, nominal wages have increased and will be further boosted by the highest minimum wage rise in four decades, at 5.1%. Business investment has been improving gradually, supported by strong corporate profits. The labour market remains tight, with the unemployment rate at 2.4% in September, and labour shortages, especially in information services, construction, transportation, and accommodation. Headline consumer price inflation remains above the 2% target, at 2.3% in October, but core inflation, excluding food and energy, has moderated to 1.6%. Real wages have been trending up over the past year. Monthly indicators suggest that the downward pressure on private consumption from the decline in real wages has started to wane.

Exports are growing, supported by the recovery in semiconductor-related product markets, and the resumption of automobile shipments, following the certification test issues, which weighed on output in the first half of 2024. Temporary factors have pushed down industrial production, but the outlook remains positive. Business confidence for the manufacturing sector has improved, with manufacturing firms projecting a 13% increase in nominal capital expenditure in FY2024 according to the Bank of Japan’s September Tankan Survey. Robust inbound tourism is supporting service exports.

In July, the Bank of Japan (BoJ) announced a short-term interest rate rise from around 0-0.1% to around 0.25% and a plan to halve Japanese Government Bond (JGB) purchases by the first quarter of 2026. The BoJ will reduce its monthly purchases of JGBs by about JPY 400 billion each quarter, targeting about JPY 3 trillion by the first quarter of 2026, which will lead to roughly a 7-8% decrease in its JGB holdings by March 2026. OECD projections of sustained inflation around 2% and robust wage growth imply further gradual increases in the short-term policy rate are warranted to 1.5% by 2026.

The underlying primary deficit is projected to widen in 2025, partly due to the new economic package, before narrowing to 1.3% of GDP in 2026 from 1.6% of GDP in 2024. The new package resumes the subsidies for gas and electricity and extends measures to curb high fuel prices. It also includes support and debt guarantees for long-term investment in semiconductor production and R&D (JPY 10 trillion, 1.7% of GDP, in the period to FY2030) and cash handouts to low-income households (JPY 30 thousand each). OECD projections assume a further increase of around JPY 1.0 trillion (0.2% of GDP) in defence spending in FY2025 and FY2026. The cost of the rise in the budget for child-related policies of around JPY 3.6 trillion (0.6% of GDP) by FY2028 is to be compensated by expenditure reforms. The gross public debt-to-GDP ratio is projected to remain high at 235% in 2026.

Real GDP is projected to grow by 1.5% in 2025, with growth reverting towards potential in 2026. Domestic demand will be the main driver of growth, with tight labour markets and high profits supporting wage growth and private consumption. Business investment will remain robust in 2025, reflecting a high order backlog in machinery and construction, and the support from government subsidies. The unemployment rate is set to edge down to 2.3% in 2026. Headline consumer price inflation is projected to converge to the 2% target as wage growth pushes up unit labour costs.

Downside risks include weaker-than-expected demand from trading partners and geopolitical tensions lowering exports. Rapid yen appreciation would reduce corporate profits and low pass-through of costs and wages to prices could disrupt the virtuous price-wage cycle, which could curtail investment. A loss of confidence in Japan’s fiscal sustainability and an increase in the sovereign risk premium could adversely affect the financial sector and the real economy. On the upside, continued high wage growth could boost consumption more than projected, while stronger-than-expected external demand could support exports further.

Addressing demographic headwinds requires further increasing labour supply and reinvigorating productivity growth. While the employment of female and older workers has been rising, the high prevalence of non-regular jobs in Japan's dualistic labour market discourages female and elderly employment, lowers on-the-job training, and slows productivity growth. Relaxing employment protection for regular workers and expanding social insurance coverage and training for non-regular workers are key. Foreign workers have almost tripled in the last decade, but the share of foreign workers remains among the lowest in the OECD. Implementing a comprehensive strategy to integrate migrants, including by preventing discrimination against them and improving their access to education and housing, would improve Japan’s ability to attract foreign workers. Reforms to improve the innovation framework and incentives for start-ups, by redesigning the R&D tax credit and strengthening the links between universities and SMEs, would boost productivity growth. Population ageing will also exacerbate fiscal sustainability challenges. Designing and implementing a medium-term fiscal consolidation path, with concrete revenue and expenditure measures, and limiting the use of supplementary budgets to large macroeconomic shocks would help rebuild fiscal buffers.