The Fed’s Misdiagnosis of the Neutral Rate and the 2026 Policy Mix

 

The Fed’s Misdiagnosis of the Neutral Rate and the 2026 Policy Mix

— Why the Risks of Reaccelerating Inflation and Asset Bubbles Are Rising

 

In December 2025, the Federal Reserve delivered its third consecutive rate cut, lowering the federal funds rate to 3.50–3.75 percent. Markets celebrated the move as confirmation of a successful soft landing, and equity indices surged to new record highs. Yet beneath this wave of optimism lies a deeper and more consequential risk: the possibility that the Fed is underestimating the true neutral interest rate.

 

The Cleveland Fed’s September 2025 Economic Commentary estimates the medium-run nominal neutral rate at 3.7 percent, with a 68 percent confidence interval ranging from 2.9 to 4.5 percent. This estimate stands notably above the Fed’s own Summary of Economic Projections, which places the long-run nominal rate at roughly 3 percent. If the Cleveland Fed’s estimate is closer to reality, then today’s policy rate—3.50 to 3.75 percent—is no longer clearly restrictive. It may already be near neutral or even slightly accommodative.

 

This interpretation aligns with the 2025 Economic Letter from the San Francisco Fed, which argues that the post-pandemic rise in real interest rates is not merely cyclical but reflects a structural upward shift in the neutral rate. Persistent fiscal deficits, a chronically tight labor market, revived investment demand, and the fading of global savings surpluses all point toward the end of the long decline in natural rates that characterized the period from the 1990s through 2020.

 

In other words, a gap may now exist between the Fed’s assumed neutral rate (3 percent) and the economy’s actual neutral rate (closer to 3.7 percent). If the Fed continues easing under the belief that policy remains restrictive, it risks unintentionally shifting into a stimulative stance—rekindling inflationary pressures that had only recently been brought under control.

 

This risk becomes even more pronounced when considering the fiscal dimension.

Public statements have suggested the possibility of distributing tariff revenues directly to American households, with figures such as “$2,000 per household” appearing in media coverage. From an economic standpoint, such a policy would have a dual effect:

• Tariffs raise prices by increasing import costs
• Cash transfers boost demand by increasing disposable income

Combined, these forces would amplify inflationary pressures from both the supply and demand sides.

 

If monetary policy is drifting toward accommodation at the same time that fiscal policy becomes more expansionary and tariffs push up costs, the result is a policy mix that bears structural resemblance to the 1970s:monetary easing × fiscal expansion × cost-push inflation.

 

Markets tend to interpret rate cuts as unambiguously positive, but if the Fed is misjudging the neutral rate, easing may instead fuel a renewed inflation cycle and inflate asset bubbles. Should tariffs and household transfers be implemented simultaneously, the bubble could grow even larger—and the eventual correction correspondingly more severe.

 

What is needed now is not a rush toward further easing, but a reassessment of the neutral rate itself. The question of where the neutral rate truly lies is not a technical footnote. It is the fulcrum on which the trajectory of the U.S. economy in the late 2020s will pivot—toward stability, renewed inflation, or a boom-and-bust cycle of historic proportions.

The Divided Rate Cut Reveals the Federal Reserve’s Structural Weakness

 

The Divided Rate Cut Reveals the Federal Reserve’s Structural Weakness

 

This morning’s Nikkei editorial, “A Divided Rate Cut Tests the Fed’s Credibility,” offers a persuasive account of the unusual dissent within the FOMC and the growing political pressure surrounding U.S. monetary policy. Yet the editorial stops short of addressing a deeper, long‑standing structural flaw—an Achilles’ heel that has quietly shaped the Federal Reserve’s policy framework for years.

 

That flaw is the Fed’s persistent and arbitrary assumption that the nominal neutral interest rate is roughly 3 percent. This assumption, rarely questioned in public debate, has profound implications for how the Fed interprets inflation, growth, and the stance of monetary policy.

The Fed’s Own Forecasts Imply a Nominal Growth Rate of Only 3.9%

In its Summary of Economic Projections (SEP), the FOMC presents the following long‑run assumptions:

• Inflation target: 2%
• Real GDP growth: 1.9%

Taken together, these imply a long‑run nominal GDP growth rate of only 3.9%.

But this is far below historical experience.
Since 1980, U.S. nominal GDP has grown at an average annual rate of 5.8%.
The Fed’s long‑run assumptions therefore paint a picture of an economy far weaker than its historical performance would suggest.

A 3% Neutral Rate Implies Real Growth of Only 1%

If the Fed insists that the nominal neutral rate is just 3%, and if inflation is anchored at 2%, then the Fed is implicitly assuming:

Long‑run real GDP growth = 1%

This is inconsistent with both the SEP’s own 1.9% real growth estimate and the historical dynamism of the U.S. economy.
The internal inconsistency is striking: the Fed cannot simultaneously assume 1.9% real growth and a 3% nominal neutral rate without contradicting itself.

A More Coherent Neutral Rate Is Around 4%

If the Fed’s long‑run nominal growth assumption is 3.9%, then the neutral rate should logically be:

• 3.9%, or
• “about 4%”, a level far easier for the public to understand.

The current 3% estimate is not only arbitrary but also analytically inconsistent with the Fed’s own projections.

The Latest Rate Cut Has Already Pushed Policy Below Neutral

With the latest 25‑basis‑point cut, the federal funds rate now stands at 3.75%.
Although this still implies a positive real policy rate consistent with the Taylor principle, it is below the true neutral rate implied by long‑run nominal growth.

In other words, the Fed has already slipped into a mildly stimulative stance, even as inflation risks remain unresolved.

If the Fed continues to cling to an artificially low 3% neutral rate, markets will naturally expect further cuts in 2026 and 2027.
Such expectations risk fueling:

• renewed inflation pressures
• asset price overheating
• and a broader erosion of policy credibility  

---

The Rate‑Cut Cycle Actually Began in August 2024

Contrary to the common narrative, the easing cycle did not begin in 2025.
It began in August 2024, when Chair Powell signaled a “preliminary rate cut” at the Jackson Hole symposium.

Since then, the policy rate has been lowered by a cumulative 125 basis points.
Yet the 10‑year Treasury yield has risen, not fallen.

This divergence suggests that markets are increasingly concerned about future inflation, and that the Fed’s credibility may already be weakening.

The Nikkei Editorial Captures the Symptoms, but Not the Cause

The Nikkei editorial rightly highlights:

• internal divisions within the FOMC
• uncertainty caused by delayed economic data
• intensifying political pressure on the Fed

These are important issues.
But they are symptoms, not the underlying cause.

The deeper problem is the Fed’s structurally flawed estimate of the neutral rate, which distorts policy decisions and undermines credibility.

 

Conclusion: Credibility Is Eroding Not Because the Vote Was Divided, but Because the Framework Is Flawed

The real threat to the Fed’s credibility is not the split vote itself.
It is the fact that the Fed continues to base its decisions on a nominal neutral rate that is too low, internally inconsistent, and historically implausible.

Unless the Fed revises this foundational assumption, inflation expectations and asset valuations will remain vulnerable to renewed instability.

This Week's Weekly: Continued: "The New Cold War Between Japan and China Is the Final Blow to Japan's Collapse"

 

This Week's Weekly: Continued: "The New Cold War Between Japan and China Is the Final Blow to Japan's Collapse"

 

Monday, December 8, 2025

 

① Regarding the Nikkei Editorial: "China's Military Provocations Are Absolutely Unacceptable"

 

While today's Nikkei editorial has some merit, it does not negate the issue. The Chinese military's radar illumination of Japan Self-Defense Force aircraft over international waters southeast of Okinawa is an extremely dangerous provocation that crosses a red line.

It is absolutely unacceptable, and the government's strong protest is understandable. Given historical precedents where accidental conflicts have escalated into war, thorough crisis management is essential.

However, the problem does not lie solely in China's provocations. Just one month ago, Prime Minister Takaichi stated in a Diet response that "a Taiwan emergency could pose an existential threat."

By failing to assume U.S. involvement and speaking as if a Taiwan emergency were a Japanese emergency, it could be said to have provided an excuse for provocation.

If both Japan and China continue to insist that the other is at fault, the Cold War-style conflict will only escalate, and there is a risk that it will become impossible to resolve.

It will not be easy for Japan and China to find a meaningful solution. The international community, not just these two countries, will have to decide which side is right.

Will the world side with Japan, or lean toward China? Which side the United States chooses under the Trump administration will be particularly crucial.

In this sense, the current situation, in which "Sanaenomics" appears to be running against history, is extremely unsettling.

Unfortunately, as detailed in last week's Weekly, Sanaenomics, which seems to be rushing headlong back down the prewar path represented by sonno joi (revere the emperor, expel the barbarians) and by Fukoku kyohei, ie. enriching the country and strengthening the military, could once again isolate our country, as happened during the last war, and send us spiraling down a slope to self-destruction.

 

② The first long-term interest rate in 18 years, 1.95%, is the "canary in the coal mine" for the Japanese economy to explode.

By the way, the December 1st Nikkei editorial, "The Bank of Japan Should Normalize Policy at Its Own Judgment and Responsibility," was persuasive in its insistence that the Bank of Japan's independence should be respected.

However, the problem lies in the lack of urgency. The Japanese economy is now in the midst of a crisis, and there is no room for leisurely discussion.

A rate hike is a drop in the bucket.

Currently, inflation is around 3%, and the supply-demand gap is roughly equilibrium. Under these circumstances, even if the policy interest rate were raised by only 0.25% from the current 0.50% level to 0.75%, it would be a gradual, delayed response and would be a drop in the bucket in terms of stabilizing prices and the currency.

As the Taylor principle dictates, the necessary conditions for price stability cannot be met without interest rate hikes exceeding the inflation rate.

Exceeding the Target for 43 Consecutive Months

It should not be forgotten that the government and the Bank of Japan have exceeded their 2% inflation target for 43 consecutive months since April 2022.

The "double whammy" of a high consumption tax rate and rising inflation is eroding consumer purchasing power, and the inflation tax continues to rob people.

According to the October Household Survey released by the Ministry of Internal Affairs and Communications last Friday (the 5th), real spending for that month was down 3.0% year-on-year, marking the first negative figure in six months.

Furthermore, the Ministry of Health, Labor and Welfare's Monthly Labor Survey for October (preliminary results, for those with five or more employees) released on the 8th showed that real wages, excluding the effects of price fluctuations, were down 0.7% year-on-year. While nominal wages have increased, they have not kept pace with inflation, marking the 10th consecutive month of negative growth since January 2013.

The Risk of an Incorrect Policy Mix

In any case, assuming an extremely expansionary "Sanaenomics" policy, the risk of accelerating inflation increases. Therefore, it is essential to not only raise interest rates by 0.75%, but to raise them continuously without delay.

Otherwise, rising inflation expectations will lead to currency depreciation and uncontrollable inflation.

According to my calculations, the appropriate interest rate, based on the Taylor rule (using an inflation rate of 3% and an unemployment rate of 2.6% as of October), should be 3.8%. The discrepancy with the current situation is quite serious.

Canary in the Coal Mine

The delay in aggressive fiscal policy and monetary tightening amid inflation appears to be pushing the vicious cycle of currency depreciation, inflation, and a bubble to the brink of exploding.

Coincidentally, long-term interest rates hit a record high of 1.95% last weekend, the lowest level in 18 years, leading to a sell-off of government bonds. This recent surge in long-term interest rates is a sign of a "canary in the coal mine."

Historically, in 1995, when the policy interest rate was 0.75%, long-term interest rates were at 3.19%. Therefore, it's possible that long-term interest rates will soon surpass not only 2% but even 3%.

Theoretically, long-term interest rates are thought to be composed of the potential growth rate, expected inflation rate, and risk premium. Both the government and the Bank of Japan estimate the potential growth rate to be approximately 0.6%. Furthermore, while the inflation target is supposed to be 2%, the actual inflation rate has been around 3% recently.

Even without considering the increased risk premium from increased issuance of government bonds due to a worsening fiscal balance, the risk of long-term interest rates rising sharply to 2.6% or even 3.6% cannot be ruled out.

Bank of Japan Accountability

Ahead of the final monetary policy meeting of the year on Friday, December 19, Governor Ueda has emphasized that "interest rate hikes are not a brake on the economy, but rather an adjustment to the accelerator toward achieving economic and price stability." Therefore, given that the government is also wary of an excessively weak yen, interest rate hikes should be tolerated at a cautious pace.

However, in a Japanese economy where the neutral interest rate remains low, continued interest rate hikes will eventually no longer be considered "adjustment in an accommodative environment." Ultimately, the Bank of Japan has a responsibility to more carefully explain to the government, the market, and the general public the appropriate pace and destination of interest rate hikes.

However, while the path to Japan's revival lies in the gradual normalization of real interest rates in addition to the abolition of the consumption tax, the Sanae and Ueda economics have fallen into the wrong policy mix of excessive fiscal spending and a continued monetary easing stance.

Thus, while it is truly regrettable, I am forced to warn that needlessly stimulating aggregate demand in the Japanese economy amid the quadruple hardships facing the general public -- a declining birthrate, long-term stagnant consumption, a weak yen, and inflation -- could lead to a major derailment from price stability and sustainable growth, and sooner or later to a major collapse of our economy. 

③ Focus on the Final FOMC Meeting of the Year

By the way, the biggest event of the week will be the US FOMC meeting, taking place on the 9th and 10th. Below, I will predict the outcome of this year's final FOMC meeting, basically following a Yahoo! Finance article from last weekend.

Since NY Fed President Williams' support for a rate cut the weekend before last, the market's view of monetary policy has been shifting. A 0.25% rate cut is now almost certain. However, according to the CME FOMC countdown as of last weekend, there is still a slightly less than 14% chance of the policy rate remaining unchanged, which may be a point of caution.

In any case, the focus will be on whether Chairman Powell's press conference and the dot chart in the latest economic outlook will change views on the pace of rate cuts in 2026.

Chairman Powell's press conference is likely to reiterate his previous view that policy decisions will be made based on data collected at each meeting, which may be perceived by the market as being somewhat hawkish.

The last dot chart, as of September, showed one 0.25% interest rate cut in 2026, one in 2027, and none in 2028. Therefore, it's highly likely that this will reinforce the sense that interest rates have already been cut in the short term.

By the way, National Economic Council Director Hassett, who is expected to become the next Fed Chairman, is "expected" to push for rate cuts, but Chairman Powell's term runs until May, so the view that rate cuts will cease at least until then may become more prevalent.

This is because, according to a Bloomberg article last week, there is an unprecedented difference of opinion among Fed officials regarding where the Fed should stop cutting interest rates after the total number of rate cuts implemented by the FOMC since the fall of 2024 has reached just over one percentage point.

Over the past year or so, the gap in views on the endpoint of the policy interest rate has widened to the widest point since 2012, when Fed officials began issuing forecasts. This situation has led to an unusually public exchange of opinions surfacing over whether to further cut interest rates at this week's FOMC meeting and what steps to take afterward.

Fed Chairman Powell has acknowledged that there are significant differences of opinion within the FOMC over which to prioritize: maximum employment or price stability. Ultimately, it boils down to whether further stimulus is needed to support employment, or whether stimulus should be withheld because inflation could exceed target and tariffs could push it higher.

Moreover, the Fed has struggled to grasp the more abstract but crucial question of the so-called neutral interest rate—the interest rate that neither stimulates nor inhibits the economy. In forecasts released in September, 19 officials suggested 11 different neutral interest rates, ranging from 2.6% to 3.9%.

In any case, it cannot be denied that the two extreme movements of the US interest rate cut and Japan interest rate hike may lead to a reversal in the foreign exchange market, with the dollar weakening and the yen strengthening, and a relative reluctance to invest in Japanese stocks. 

④ The Recklessness of the "Predetermined Conclusion" Bill

The December 3rd Asahi Shimbun editorial, "The Recklessness of the 'Predetermined Conclusion' Bill to Reduce the Number of Houses of Representatives," presents a very persuasive argument.

The crux of the problem lies not in the number of House of Representatives seats themselves, but in the deeply rooted structure of hereditary succession, privilege, and vested interests within the ruling Liberal Democratic Party.

Therefore, the true political reform priority should not be "reducing the number of seats," but rather reducing annual salaries. The first step toward regaining public trust is for lawmakers to demonstrate a willingness to cut into their own privileges.

The Problems with the Reducing the Number of Houses of Representatives Bill

The LDP and the Japan Restoration Party have agreed to "reduce the number of seats in the House of Representatives by 10%," aiming for passage during the extraordinary Diet session. If no conclusion is reached within one year, they are seeking to introduce a system that automatically reduces the number of seats in 25 single-seat districts and 20 proportional representation districts.

This is a reckless approach based on a "predetermined conclusion" and disregards the broad consensus necessary for electoral reform, which is the foundation of democracy.

Why "Salary Reductions" and Not "Reducing the Number of Seats"?

Japan's parliamentary system is by no means large. Despite its smaller population than Japan, the British House of Commons has 650 seats, more than the 465 seats of the House of Representatives. A parliamentary cabinet system requires a certain number of members.

While I understand the "sacrificial attitude of politicians" advocated by the Japan Innovation Party, there are other effective reform measures, such as reviewing corporate and organizational donations and reducing party subsidies.

Furthermore, reducing the number of members of parliament due to population decline is unconvincing. The population decline rate since 1994 has been only 1.7%, and the number of seats has already been reduced from 500 to 465.

Danger of Narrowing the Channel for Delivering Public Will

Diet members represent the people, and needlessly reducing the number of seats will narrow the channel through which public will is reflected in national politics.

The current electoral system, consisting of single-seat districts and proportional representation, was introduced with a "two-party system" in mind, but the current situation is moving away from that ideal. Rather, it is time to reconsider the system for selecting representatives so that it is appropriate to the diversifying values ​​of the people. A system that states "if no conclusion is reached within one year, automatic reductions will occur" is tantamount to a threat to political parties that wish to engage in careful discussion.

Reducing the number of seats is a dangerous argument that distorts the essence of political reform. What is truly needed are reforms in which politicians themselves address vested interests, such as reducing Diet member salaries and reviewing corporate and organizational donations.

Substantial reforms to regain the trust of the people should be prioritized, rather than "predetermined" reductions that undermine the foundations of democracy. 

⑤ Budget Efficiency Requires Evidence-Based Policy Verification

 The December 4th Nikkei editorial, "Budget Efficiency Requires Evidence-Based Policy Verification," appears persuasive at first glance. However, it cannot be dismissed without problems.

 

Political "Reform Pretense" and Its Limitations

The LDP, increasingly hereditary, privileged, and vested interests, and the newly elected Ishin Party, are essentially no different. "Reform pretense" without soul is merely pie in the sky and lacks effectiveness.

Like the government's price control measures, policies that are supposed to be based on "evidence" actually lean toward worsening, ignoring reason and facts and pursuing a self-destructive path—that is the nature of "Sanaenomics."

Short-sighted performances to the public and the media will eventually lead to disappointment and alienation.

 

The Launch of the Japanese Version of DOGE (Ministry of Government Efficiency) and Its Challenges

The Takaichi Cabinet's "Japanese Version of DOGE (Ministry of Government Efficiency)" has been launched. The plan calls for a comprehensive review of special tax measures (Tax Measures), subsidies, and funds, and for funds to be restructured through revisions and abolition. This should be done without political motives and based on evidence-based verification of policy effectiveness.

The Japanese version of DOGE was proposed by the Japan Innovation Party, and is inspired by the DOGE initiative led by Elon Musk under the Trump administration. The LDP-Japan Innovation Party coalition agreement clearly states that "policy measures with low policy effectiveness will be abolished."

The role will be played by a dedicated office within the Cabinet Secretariat, overseen by Finance Minister Katayama. However, the Japan Innovation Party's aim is to secure funding for free high school tuition. It would be premature to directly link the review of tax measures and subsidies to issues that should be discussed in conjunction with the quality of education and the future vision of high schools.

Review of the Wage Increase and Research and Development Tax System

The Japan Innovation Party advocates a review of the wage increase promotion tax system and the research and development tax system. The total tax reductions under the special tax system will reach 2.9 trillion yen in fiscal 2023, of which 1.7 trillion yen will be achieved through both tax systems.

Markets are concerned about the Prime Minister's proactive fiscal policy, leading to rising long-term interest rates and a weaker yen. Looking back at the budget review conducted during the Democratic Party administration, it is extremely difficult to contain budget expansion through a Japanese version of DOGE alone.

Wage increases and R&D investment are fundamental to tackling rising prices and growth strategies, so it is essential to design systems that do not result in losses for proactive companies. Are tax systems truly providing incentives, or are they merely a retroactive benefit?

An evidence-based analysis is required, taking into account comparisons with policies in other countries.

Toward the core of administrative and fiscal reform

Improving government efficiency goes beyond special tax systems and subsidies. Policies that target those truly in need, such as tax credits with benefits, require the sharing of income and asset information between the national and local governments.

We must accelerate administrative and fiscal reform through digitalization and the use of AI.

Tomo Nakamaru, former World Bank economist

This Week's Weekly: The ¥21 Trillion-Plus Economic Stimulus Package is the Fuse for a Weak Yen, Inflation, and a Bubble Explosion

 This Week's Weekly: The ¥21 Trillion-Plus Economic Stimulus Package is the Fuse for a Weak Yen, Inflation, and a Bubble Explosion—The Double Whammy of a 10% Consumption Tax and an Accelerating Inflation Tax Will Only Further Exploit the Common People

 

Monday, November 24, 2025

 

① Will the ¥21 Trillion-Plus Economic Stimulus Package Be Enough to Alleviate Concerns about Living?

 

The Mainichi Shimbun's editorial on Saturday, November 22nd, was quite persuasive, stating, "Simply inflating the budget unchecked will not alleviate the concerns of the people suffering from rising prices." Below, we borrow an excerpt from the editorial to highlight the dangers of Sanaenomics, which proposes a supplementary budget exceeding ¥21 trillion.

 

The Takaichi Sanae administration has decided on its first economic stimulus package since taking office. It emphasizes "active fiscal policy" and totals over ¥21 trillion, more than ¥6 trillion more than last fall's package. This means the administration is planning a massive fiscal stimulus policy amounting to 3.5% of nominal GDP of approximately 600 trillion yen.

 

If we assume that the fiscal policy multiplier coefficient is the usual 1.5, the aggregate demand stimulus effect would be just over 32 trillion yen, 1.5 times the 21 trillion yen. The aggregate demand stimulus effect relative to GDP would be amplified by 5.3%.

 

In contrast, according to the government and the Bank of Japan, the potential growth rate of the Japanese economy is only about 0.6%. Therefore, excessive aggregate demand stimulation by fiscal stimulus could trigger inflation of as much as 4.7%, corresponding to this gap. In fact, as detailed in Section 3, the October national CPI already suggests that inflation could reach 5% in the near future.

 

In this way, far from addressing rising prices, Sanaenomics is playing with fire, adding fuel to the fire of accelerating inflation and potentially turning the Japanese economy into a scorched earth.

 

Specifically, the government's top priority measures to combat rising prices can hardly be described as handouts. In addition to abolishing the temporary gasoline tax, subsidies for winter electricity and gas bills will be significantly increased starting this summer.

 

Low-income earners are the ones hit hardest by rising prices. Support should be prioritized for these groups. However, if support is given generously to high-income earners as well, it is obvious that this could overly stimulate consumption and contribute to price hikes.

 

Furthermore, the distribution of "rice coupons" that allow people to buy rice cheaper cannot be overlooked. While large grants will be provided to a wide range of local governments as financial resources, this reduction in the burden on consumers is only temporary. The fundamental problem of a weakening production base is being covered up, and prices will remain high.

 

Adopting the Komeito Party's proposal to add 20,000 yen to child allowances across the board is also spurring inflation. While the government's minority government likely aims to gain cooperation in passing the budget, it would be irresponsible to swallow it whole without considering financial resources.

 

The effectiveness of large-scale investments in areas deemed essential is also being questioned. The prime minister claims to increase growth potential to realize a "strong economy," raising wages and increasing tax revenue. However, investments are prominently focused on industries that have been left behind in international competition, such as semiconductors and shipbuilding.

 

In the end, large-scale measures will not be covered by tax revenue, and a large amount of additional government bonds will have to be issued. Concerns about a worsening fiscal situation are growing in financial markets, accelerating yen selling.

 

The weak yen has been a major factor in the rise in prices since April 2022. While raising interest rates by the Bank of Japan would lead to a correction, the prime minister has maintained a cautious stance. A further decline in the yen could lead to further price increases.

 

Government bonds are also being sold in the market, and long-term interest rates have risen to their highest level in 17 and a half years. Not only will interest payments on the debt mount, passing the burden on to future generations, but the sudden fall in government bond prices will also raise concerns about the finances of regional banks and other financial institutions holding large amounts of long-term government bonds, as unrealized losses grow.

 

The Prime Minister has emphasized that he will "turn anxiety about the future into hope." However, prioritizing short-term popularity will only leave a lasting legacy of serious problems.

 

② Japan's Debt Denial: Japan's Long-Term Interest Rates are Showing Debt Crisis Signs

In this section, we introduce a very interesting tweet dated November 23rd by Robin J. Brooks (a senior fellow at the Brookings Institution and former FX analyst at Goldman Sachs):

"Japan is in denial. For years, despite its massive government debt, long-term interest rates have been very low, creating the illusion that this was somehow normal. This is not the case. Low interest rates are artificial, brought about by the Bank of Japan's (BOJ) massive purchases of government bonds and the imposition of yield caps. This approach ran into problems after the COVID-19 pandemic. As central banks raised interest rates to contain inflation, long-term government bond yields began to rise globally. The BOJ continued to cap long-term interest rates, but this was due to the weak yen. It spiraled. The yield cap was no longer sustainable.

"What you need to know about Japan's long-term interest rates is that, even after their recent rise, they remain artificially low. After all, as we've noted in this article, the Bank of Japan (BoJ) remains a large buyer of Japanese government bonds on a gross basis. Imagine how high Japanese yields would be if the BoJ truly withdrew from the market. Japan's "shadow" long-term yields—the yields that would equilibrate the market in the absence of BoJ bond purchases—are much higher than we're seeing. "

"The easiest way to see how deeply skewed Japan's long-term yields are is with the graph below. The horizontal axis shows total debt as a percentage of GDP. The vertical axis shows 30-year government bond yields. Eurozone countries are in red, other G10 countries are in blue, and Germany (DE) and Japan (JP) are in black. Germany's debt in 2024 was 65% of GDP, Japan's was 240%. Yet the yields on their 30-year government bonds are the same. This is a sign of major mispricing, showing that Japanese government bond yields are far below where they should be.

"Japan has options. The alternative is to let the market set yields without BOJ intervention, which would stabilize the yen but lead to a significant rise in long-term interest rates and a debt crisis. Or to cap yields, which would keep the yen falling. Sanae Takaichi hopes this will differentiate her from her predecessor, but expanding debt-fueled stimulus will only make things worse and demonstrate that the highest levels of government do not understand how precarious Japan's debt situation is. It is easier to remain trapped in the deception than to acknowledge the unpleasant reality.

 

③ October's national CPI growth rate accelerated to +4.9% year-on-year, driven by a sharply weaker yen.

 

The Ministry of Internal Affairs and Communications announced the October national consumer price index (core CPI excluding fresh food) on Friday, November 21st. The year-on-year growth rate expanded for the second consecutive month, reaching the 3% mark for the first time in three months. Core CPI rose 3.0% year-on-year, up from a 2.9% increase in September. This marks the 43rd consecutive month that the CPI has exceeded the Bank of Japan's target of 2%.

 

Food prices excluding fresh food remained strong, rising 7.2%, while rice prices rose 40.2%. Energy prices rose 2.1%. It's unfortunate that, like the Nikkei article and others, the Bloomberg article only focuses on the year-on-year inflation rate, pointing out that factors such as auto insurance premiums (up 6.9%) and hotel rates (up 8.5%) were driving the increase.

 

This is because Western media typically analyzes time series data trends not only in year-on-year comparisons, but also in seasonally adjusted month-on-month comparisons. The former can result in a delay in recognizing changes in economic indicators such as inflation over a six-month period compared to the latter.

 

Looking at month-on-month comparisons, it is noteworthy that the national CPI for October was +0.4% (+4.9% annualized) on an overall, core, and core-core basis, indicating a significant acceleration of inflation.

 

This coincides with the October PPI's +0.4% month-on-month change, and it is clear that behind this is the significant month-on-month decline in the dollar-yen exchange rate. The dollar-yen exchange rate went from around 148 yen at the end of September to around 154 yen at the end of October, a significant monthly depreciation of the yen and appreciation of the dollar of -4.1%.

 

At its October meeting where it decided to maintain the current monetary policy, the Bank of Japan emphasized that there would be disinflation (a decline in the rate of price increase) in the future. However, rice prices rose significantly in October, by 5.3% compared to the previous month (annualized increase of 85.8% compared to the previous month), and recorded a 40.2% increase compared to the same month last year.

 

④ The Significance of Q3 GDP, the First Real Negative Growth in Six Quarters

 

Now, the Cabinet Office released the preliminary GDP figures for the July-September 2025 quarter on Monday, November 17. While this represents the first quarter-on-quarter negative growth in six quarters, it is not a second consecutive quarter of negative growth and does not technically qualify as a recession.

 

Both personal consumption and corporate capital investment maintained positive growth compared to the previous quarter, indicating that the Japanese economy is not entering a structural contraction. Furthermore, there is a possibility that corporate capital investment and other forecasts may be revised upward in the upcoming second revision.

 

In any case, this was a temporary negative growth resulting from a combination of special factors, including a rebound decline in housing investment. Rather, we must not lose sight of the fundamental challenges facing the Japanese economy: the vicious cycle of currency depreciation and inflation.

 

In fact, the GDP deflator rose 0.6% quarter-on-quarter and 2.8% year-on-year, indicating that inflation continues to exceed 2% not only on a CPI basis but also on a value-added basis. This is not a temporary phenomenon, but a sign of structural upward pressure on prices.

 

To overcome the quadruple challenges facing the Japanese economy -- a declining birthrate, long-term stagnant consumption, a depreciating currency, and high prices -- an appropriate monetary and fiscal policy mix centered on the normalization of monetary policy and the abolition of the consumption tax is essential.

 

The current negative GDP growth is only a temporary phenomenon, but this situation should be seen as an opportunity to reaffirm Japan's path to recovery.

 

⑤ A New Cold War Between Japan and China Could Be the Final Blow to the Quadruple-Worse Japanese Economy

 

This morning's Asahi Shimbun editorial, "Japan-China Relations: Putting an End to the Fruitless Conflict," dated Tuesday, November 18th, was persuasive overall. However, it also contains some issues that cannot be overlooked.

 

This is because we must not overlook the fact that one of the causes of the fruitless conflict in Japan-China relations is Japan's own words and actions. The first step toward truly restoring trust is to frankly admit our fault and demonstrate a willingness to exercise self-control.

 

Simply seeking improvement in China's overreactions and hardline stance, which Japan cannot directly control, risks making the situation worse. Diplomacy should involve assessing the other party's actions while calmly adjusting one's own position.

 

In any case, the editorial is noteworthy, especially as it documents the rapidly escalating issues between Japan and China. Below are its key points.

 

Immediately after Prime Minister Takaichi shook hands with Chinese President Xi Jinping in late October and agreed to "build a constructive and stable relationship," Japan-China relations rapidly deteriorated.

 

The trigger was a comment made by Prime Minister Takaichi in a Diet response on November 7. Regarding China's response to a Taiwan emergency, she said, "If it involved the use of military force using battleships, it could pose an existential threat."

 

This comment goes beyond the views of previous administrations, including the Abe administration that enacted the security legislation. Moreover, by mentioning the name "Taiwan," it must be said that it unnecessarily escalated tensions.

 

The Chinese government has firmly maintained its position that "Taiwan is an inalienable part of China," and the Japanese government has pledged to respect this. Previously, Japan has limited its statement to the "importance of peace and stability in the Taiwan Strait," but these recent comments go beyond that.

 

China reacted strongly, summoning its ambassador to China to protest. Furthermore, it is difficult to understand the government's attempts to spread the conflict between governments to the private sector, such as by calling for people to refrain from traveling and studying abroad.

 

In addition, the abusive social media posts by Xue Jian, China's Consul General in Osaka -- "We will have no choice but to cut off that filthy head without a moment's hesitation" -- are completely unacceptable for a diplomat. Although the posts have been deleted, no explanation has been offered and the Chinese Ministry of Foreign Affairs has defended them, which is unacceptable.

 

It is only natural that the Japanese government protested against such provocative behavior. However, what is important here is for our country to maintain calm and restraint and avoid escalating the situation. In light of Xue's past behavior and remarks, there are calls for him to "exit the country," but hasty action could be counterproductive.

 

Japan-China relations can only be stabilized through mutual trust and moderate dialogue. Japan itself must first be deeply aware of the weight of its words and the historical context, and maintain a cautious diplomatic stance.

 

China's responses so far have been limited to (1) a de facto ban on imports of Japanese seafood, (2) calls for people to refrain from travel to Japan, (3) postponements of Japanese film releases and cancellations of events, and (4) the postponement of ministerial meetings at the request of China.

 

However, depending on Japan's future response, we cannot rule out the possibility that China may resort to its trump card, such as restricting or banning rare earth exports to Japan.

 

In any event, any further escalation of the Sino-Japanese cold war could have a fatally negative impact on the Japanese economy.

 

⑥ The Mystery of Japanese Stocks' Much-Hated Ups and Downs Over NVIDIA's Earnings

By the way, the wild fluctuations in the Nikkei Stock Average last week surrounding NVIDIA's earnings results, which could be described as "much-hated ups and downs," are thought to be primarily due to a combination of the following factors.

1. Background to the Rise (Excitement and Relief Over NVIDIA's Strong Earnings)

• NVIDIA's "Super" Strong Earnings

o At the start of the week (November 20th), NVIDIA's quarterly earnings, announced the previous day (November 19th, US time), showed record profits that far exceeded market expectations and provided a bullish earnings outlook.

o NVIDIA is the largest semiconductor (GPU) manufacturer driving the AI ​​boom, and its earnings results were closely watched worldwide as a test of the sustainability of the "AI boom."

• Impact on Semiconductor-Related Stocks in the Japanese Market

• Huge buying activity was concentrated in Japanese semiconductor-related stocks (such as Tokyo Electron, Advantest, and SoftBank Group, which are high-value stocks that contribute significantly to the Nikkei 225 index) where NVIDIA has many customers and suppliers, due to expectations of continued demand for AI.

• As a result, the Nikkei 225 index soared by more than 2,000 yen at one point, recovering to the 50,000 yen range. This likely included buybacks by investors who had reduced their positions due to excessive caution prior to the earnings announcement.

• 2. Background to the Sharp Drop (Lumbersome Reaction in the US Market and Rekindled Overheating)

• Sluggish Growth of NVIDIA Stock in the US Market

• Immediately after the earnings announcement, NVIDIA shares rose sharply in after-hours trading, but once full-scale US market trading began, their shares stagnated and ultimately closed in the red.

Because the market's strong earnings results had already priced in high expectations, the market viewed the news as "all the news has been released," and the "bubble-like overheating of the AI ​​boom" persisted.

 

• Renewed recognition of overheating in the Japanese market and profit-taking

• The decline in NVIDIA shares in the U.S. market eroded the sense of relief that the "AI boom is not over," and in turn rekindled concerns about overheating in Japanese semiconductor-related stocks.

• Because it came immediately after a surge, short-term profit-taking sales dominated, leading to a sharp drop of over 1,000 yen the following day (November 21).

• Other external factors (correction trend)

• The Nikkei average had already entered a correction phase since the beginning of the week due to concerns about prolonged U.S. monetary tightening, falling U.S. stock prices, and concerns over certain political and economic developments. The event occurred amid a weak market sentiment. While NVIDIA's earnings results temporarily offset this trend, subsequent developments accelerated the correction trend once again.

 

This series of movements shows that the "AI boom" is the most important theme in the stock market today, and that the financial results of NVIDIA, its core company, have an extremely large influence on Japan's major tech stocks and, by extension, the Nikkei Stock Average.

• Skyrocket: The enthusiasm was caused by the market's biggest concern (the end of the AI ​​boom) being temporarily alleviated by NVIDIA's extremely strong financial results.

• Sharp drop: The subsequent reaction of the US market led people to conclude that "stock prices are not growing despite good financial results = the sense of overheating is still strong," and short-term investors concentrated their selling efforts to take profits and avoid risk.

 

In short, amid a tug-of-war between "expectations" and "caution over overheating" regarding the huge theme of the AI ​​boom, stocks that contribute significantly to the Nikkei Stock Average reacted strongly to this, resulting in extreme price movements.

 

7. US Employment Growth Exceeds Expectations, Unemployment Rate Rise to 4.4% - Reflecting Labor Market Instability

 

To conclude this week's weekly report, let's take a look at the latest US economic indicators, as the government shutdown has finally been lifted and the publication of US economic indicators has finally begun to partially resume.

 

In the September US employment report, nonfarm payrolls increased by 119,000, beating market expectations. However, August's figure was revised downward to a decrease. The unemployment rate also rose 0.1 percentage point from the previous month to 4.4%, reaching its highest level in nearly four years.

 

By industry, healthcare and leisure/hospitality saw notable employment growth. Meanwhile, manufacturing, transportation/warehousing, and business services saw declines. Private sector employment increased by 97,000, the largest increase in five months and exceeding market expectations.

 

Notably, the labor force participation rate reached 62.4%, the highest level in four months. Women contributed to the increase. The "prime working generation" (ages 25-54) maintained its highest level in a year.

 

Average hourly earnings increased 0.2% from the previous month (compared to market expectations of a 0.3%), the slowest growth since June. Compared to the same month last year, they were up 3.8% (compared to 3.7%).

 

In the end, the September employment statistics may be seen as providing some reassurance that the US labor market was not in a state of collapse before the government shutdown.

 

By the way, the US Bureau of Labor Statistics announced on the 19th that it will not release October employment statistics. The October employment data will be incorporated into the November data, scheduled for release on December 16th.

 

Since the next FOMC meeting is on December 9th and 10th, this September's employment statistics will be the last to be released before the FOMC meeting. The release of the October CPI has also been canceled, with the November data scheduled for release on the 18th, after the December FOMC meeting.

 

Finally, as I pointed out at the beginning, it is truly unfortunate that Sanaenomics and Ueda's Bank of Japan appear to be heading in the exact opposite direction from the traditional path of economics, almost as if they are "crazy."

If things continue like this, I worry about what will happen to Japan as we approach the New Year holidays. A crash, dissolution of the Diet, or a general election is not out of the question.

In any case, let's overcome this greatest challenge since the war.

I believe that crisis is also a great opportunity.

 

Ｔomo Nakamaru, Former World Bank Economist