Introduction to Japan’s Economy
Japan’s economy was expected to struggle in 2025, with forecasts predicting slow growth and a stagnant monetary policy. However, despite these expectations, the data tells a different story. Growth has been stronger than anticipated, wages are starting to rise, and households continue to spend. This unexpected turn of events has led to a reevaluation of Japan’s economy, with many now realizing that it is more resilient than initially thought.
Growth Defying Expectations
Revised figures confirm that Japan’s economy expanded at an annualized pace of 2.2% in the second quarter, double the government’s initial estimate of 1.0%. This growth has been consistent, with the economy now having grown for five consecutive quarters, a stretch not seen in years. Household consumption continues to rise, and business investment has advanced 0.6% in Q2. Net exports have also added 0.3 percentage point to growth, partly due to shipments being front-loaded before new US tariffs took effect.
Wages and Spending: A Positive Cycle
The tight labor market is the backbone of Japan’s current expansion. The unemployment rate is currently 2.5%, and labor force participation has climbed to its highest level since the late 1990s. Employers face structural shortages, pushing them to offer higher hourly pay even as overall hours worked continue to decline. This year’s spring wage negotiations delivered an average 5.3% increase, the strongest since the 1990s. Nominal wages rose in July at the fastest pace in seven months, and real wages have edged into positive territory as food and energy inflation cooled.
Inflation: A Cooling Trend
Headline inflation has slowed from 4% in January to around 3.5% in May and further to 3.1% in August. Food prices remain high, but broader food inflation has started to fall. Core inflation, which strips out food and fuel, stood at 3.4% in August but remains controlled. The Bank of Japan is confident that headline inflation will fall back to its 2% target in fiscal 2025-26. However, the risk lies in services, as demand for services could push prices higher.
Trade Headwinds: A Challenge for Japan
Trade remains a weak spot for Japan. Despite striking a deal with the US to cut tariffs on autos, exports to the US fell 10.1% in July from a year earlier. Exports to China also dropped 8.8% in May, the third monthly fall in a row. The drag from trade is hitting profitability, which finances wage growth and capital expenditure. If tariffs stay in place into 2026, Japan will need stronger domestic demand to offset the lost external income.
Politics: The Real Risk for Investors
Prime Minister Shigeru Ishiba’s resignation has added a new layer of uncertainty. The Liberal Democratic Party has lost its majority in both houses, and a leadership election in October will decide the country’s next direction. The contenders within the LDP differ in their approach, with one favoring fiscal expansion and a softer monetary stance, while another emphasizes structural reforms and neutrality on the BoJ’s normalization path. The lack of parliamentary majority makes bold policy changes unlikely.
The Bank of Japan’s Dilemma
The Bank of Japan is caught between solid data and political risk. Before Ishiba’s resignation, markets were pricing a 70% chance of a rate hike by year-end. After Ishiba’s resignation, those odds dropped to around 40%. Policymakers insist that if their growth and inflation forecasts hold, rates will rise. However, the optics of tightening during a political transition are awkward. Most economists expect no change at the September 19 policy meeting, with October remaining in play but the risks of delay having grown.
What Investors Should Watch Next
For investors, the key is not whether Japan posts 1% growth or 1.2% this year. The real test is whether the wage-price cycle holds through the winter and into the 2026 wage negotiations. If firms continue to deliver pay rises that outpace inflation, consumption will remain strong enough to offset trade weakness. Three signposts matter most: wage and household spending data through autumn, export performance outside the US, and the composition of fiscal relief measures after the LDP leadership contest.
Conclusion
Japan’s economy in 2025 is not the fragile story it once was. It is not roaring, but it is resilient. The risk now lies less in the data and more in the politics. As the country navigates its political transition, investors should keep a close eye on the wage-price cycle, trade performance, and fiscal policy. The Bank of Japan’s decision on interest rates will also be crucial, as it balances solid data with political uncertainty. Overall, Japan’s economy has defied expectations, and its resilience will be tested in the coming months.
