Japan Confronts Impossible Policy Dilemma Amid Rising Inflation and Interest Rates

Japan's public debt has reached an astonishing 230% of its GDP, making it the highest among advanced economies. Despite this, the country largely avoided a debt crisis for over three decades. However, the situation is now changing due to rising inflation and increasing borrowing costs.

The Bank of Japan (BOJ) played a crucial role in maintaining exceptionally low borrowing costs through its quantitative easing policies. The BOJ owns roughly half of all outstanding Japanese Government Bonds (JGBs), with its balance sheet expanded to over 100% of GDP, an unprecedented scale among major advanced-economy central banks.

The return of inflation has altered the economic environment that allowed Japan to sustain high public debt at low borrowing costs. Headline inflation has remained above the BOJ's 2% target, and yields on JGBs have risen to levels not seen in many years. The government's debt-servicing burden will inevitably increase as older debt matures and is refinanced at higher interest rates.

The yen's decline reflects diverging monetary policies between Japan and other major economies. While the US Federal Reserve and European Central Bank raised interest rates, the BOJ proceeded with caution, only ending its negative interest-rate policy in 2024. The widening interest-rate differential encouraged capital to flow into higher-yielding assets abroad, leading to a depreciation of the yen.

Japan now confronts a policy dilemma that resembles an impossible triangle. Higher interest rates are needed to contain inflation and stabilize the yen, but they raise government borrowing costs at a time when public debt exceeds 230% of GDP. Renewed large-scale monetary easing would risk further weakening the currency and reigniting inflationary pressures.