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In January, the Bank of Japan (BOJ) raised short-term interest rates to 0.5%, the highest level seen in 17 years, as it continued with its slow but steady withdrawal of accommodation. As the Japanese economy shows ongoing signals of recovery from decades of stagnation, we assess the impact the return of interest rates could have on the country’s households, firms and government.

Households have both push and pull power for prices

Households include consumers, borrowers such as mortgage holders, savers, investors and wage-earners. A large part of the BOJ’s deliberations over exiting negative interest rates and then gradually withdrawing stimulus was influenced by household sentiment. The BOJ purposefully positioned itself “behind the curve”, allowing two full years for both headline and core inflation to approach its target before taking action. Next, it ensured that households were gradually breaking away from their deflationary mindset. This shift was evident in terms of wages as the spring “Shunto” round of negotiations had for several years resulted in solid wage increases by the time the BOJ exited negative rates and yield curve control. Additionally, the pass-through of raw to final goods price rises to consumers became possible thanks to the rise in wages. The impact on employment will be covered in more detail under “firms”.

As prices rose, however, small changes started to be observed in households’ saving and investment behaviours. Price rises led to wage increases (which were reinforced by a structural labour supply shortage), but with some delay. This meant households were unable to save as much as they did during deflation, when goods had increasingly cheapened. Meanwhile, the rationale for holding cash diminished as savings rates dropped. Unlike during deflation, holding cash today cannot guarantee greater real consumption in the future. Furthermore, the rise in asset values (also covered under “firms”) helped to reintroduce the concept of the “time value” of money. This new financial landscape highlighted not only the loss of purchasing power from holding zero-interest-rate savings, but also the opportunity cost of failing to take advantage of the compounding effect of a positive yield over time.

In this context, the timing of the introduction of the new NISA scheme was impeccable (see “government” for more). The new NISA scheme took effect in 2024, just as corporate profitability was improving and households were starting to realise that they were losing purchasing power. Savings moved from cash to equities and mutual funds between the end of FY2023 and the start of FY2024; BOJ data show a noticeable percentage point increase in households’ equity share, while the proportion of cash savings had decreased as of August 2024 (Chart 1). Mortgages tend to be repriced with a substantial lag to interest rates, sometimes in increments spanning five years, which justifies the BOJ’s gradualist wait-and-see approach to withdrawing stimulus.

Chart 1: Households have started increasing their investments into equities

Source: BOJ

Firms: signalling recovery in “economic metabolism”

The rise in Japan’s nominal GDP marked a structural shift; the economy is no longer deflating its way to positive real growth. Since revenues are calculated in nominal terms, this was good news for firms, leading to a surge in corporate profits. At first, it appeared as though the weakness of the yen only benefited large-cap exporters. However, gradually, non-manufacturing and services sector firms were also able to raise their profit margins. This became even more pronounced when input price inflation subsided.

The return of positive interest rates can have contrasting effects on firms. While it could be negative for firms reliant on ultra-low rates, it can be positive for firms that are able to boost margins more rapidly than the rise in their cost of capital. Some firms left the market, but this was mostly due to reasons other than higher interest rates. Amid labour supply shortages, bankruptcies spiked during the pandemic due to firms’ inability to attract and retain labour, and this trend never fully subsided.

We are now in an environment where not only does money have time value, but labour is also clearly scarce. Some of this market attrition can be viewed as healthy. While Japan’s “lost decades” saw firms being subsidized to prevent unemployment from spiking, the current structural labour shortage has made such measures redundant. As a result, unprofitable firms can now leave the market without causing significant damage to households. However, interest rates do affect corporate financing with a lag when firms need to refinance. This is another reason why the BOJ has been very deliberate in the pace at which it is withdrawing stimulus.

Overall, bankruptcies remain low, even as the ratio of bankruptcies in services (labour-intensive sectors) to manufacturing remains near record highs. The financial sector could benefit from higher interest rates by regaining higher margins as domestic demand recovers.

The return of positive rates—and the time value of money—provides a good discount to invest today for future cash flows. Firms are indeed investing, not only in fixed assets to replace fully depreciated capital, but also in intangibles such as software in a bid to raise future productivity and allay labour supply shortages with automation and software solutions. Aided by the government’s enhanced corporate governance guidelines, these measures are creating shareholder value.

Recently, Japan’s equity risk premium achieved a level competitive with the US equity risk premium, indicating that Japanese companies offer competitive compensation for risk undertaken. This is important in an environment where risk and time are key considerations in determining the value of future investments.

Government: finally placed to inflate away decades of debt expansion

One worry that investors have expressed is the potential surge in the cost of debt financing that accompanies a rise in interest rates. Since the government is the largest debt issuer in Japan, with a gross debt-to-GDP ratio of over 200%, this is a significant concern. However, Japan’s current account surplus provides a buffer. The surplus means that most of these assets are held domestically, primarily to offset domestic liabilities. Although we have seen long-end Japanese government bond yields rise as the BOJ has removed stimulus, Japanese institutional investors have remained strong enough, even if sometimes reluctant buyers.

Meanwhile, we favour the “r-g” measure, which is the difference between real interest rates and real growth, to gauge whether policy is accommodative or restrictive. This measure is not only important to firms (r-g is in the denominator of Gordon growth or dividend discount models, meaning that the smaller it gets, the higher your valuation estimate) but also for the government. When real rates are below real growth, it is possible to reduce debt through inflation. Indeed, a look at the comparative rise in government tax receipts versus expenditures shows that the government has been implementing this strategy so far.

Chart 2: Japan’s real interest rates – real GDP growth

Source: Nikko AM, BOJ, CAO

Of course, to successfully inflate away debt, the government will have to maintain its long-term commitment to return to primary balance surpluses. A couple of years of good tax receipts will not replenish its coffers. However, the increase in tax receipts also means that the government does not need to implement fiscally austere measures simply to decrease its deficits.

In classical economic theory, the government’s goal is to maximise the aggregate welfare of households, which are the ultimate owners of firms. The introduction of the new NISA scheme therefore was a rational decision, coinciding with the economy’s reflation and the restoration of the time value of money. Households showed they do care about lifetime wealth (since inflation reduces uninvested wealth in the future) by investing in firms and increasing consumption.

As mentioned above, households have started to shift their savings towards investment, which, from the government’s view, is also a move in the right direction for improving overall welfare. Investment today by a household equals consumption sometime in the future, determined not only by the savings rate but by the return on investment. To be able to consume the same amount in the future, households are starting to recognise that positive returns are essential, and that it is necessary to compound these returns over time. From the government’s perspective, this is a signal that asset-holders are taking risk (and being rewarded for it), which is a step in the right direction.