This Week's Weekly: "The Overshoot Model" and Memories of My Time at the World Bank and GWU: In Memory of the Late Columbia University Professor Takatoshi Ito

 

This Week's Weekly: "The Overshoot Model" and Memories of My Time at the World Bank and GWU: In Memory of the Late Columbia University Professor Takatoshi Ito

 

Monday, December 29, 2025

 

 

① Japan and the World Fear a "Neutral Interest Rate Revolt" at the End of the Year

 

Since the fall of 2025, the global economy has been enveloped in a strange calm. Stock prices remain at high levels, and unemployment rates remain largely at historically low levels.

 

Central banks have repeatedly emphasized a "soft landing," and the market has accepted their words without question.

 

However, this calm is merely a harbinger of major tectonic shifts. In fact, in the United States, nominal GDP growth exceeded 8% annualized in the July-September quarter of 2025. Real economic growth also reached the 4% range, and the labor market does not necessarily appear to be weakening.

 

Inflation is rising again after a temporary lull, wage growth is tenacious, and corporate pricing power is actually strengthening.

 

Furthermore, the November 2025 U.S. CPI data, which fell significantly below market expectations, was collected only for the middle and latter half of the month. It's reasonable to assume that the late-November data, including Thanksgiving, was simply skewed downward compared to the complete November 2024 data due to bargain sales.

 

In any case, the U.S. policy interest rate is 3.75%. The Federal Reserve has clung to its outdated assumption that the "neutral interest rate is around 2.5% to 3%, and the market has also gone along with that illusion.

 

However, nominal GDP growth and nominal policy interest rates have historically moved in the same direction. This is not just a rule of thumb; it's a law of economic gravity.

 

In a world with a nominal growth rate of 8%, policy interest rates cannot remain at 3% to 4%. This discrepancy is sure to be corrected eventually. And this correction will not always be "gradual";

it could manifest as a sudden reversal.

 

In the 1970s, the Fed underestimated the neutral interest rate, allowing inflation expectations to spiral out of control.

 

In 1994, a mismatch between the Fed's and the market's understanding of the neutral interest rate devastated the bond market.

 

In 2021-2022, the Fed mistakenly believed inflation was "temporary" and was forced to rapidly raise interest rates as a result.

 

And now, as we head toward 2026, it appears the world is on the verge of repeating the same mistake again.

 

However, the epicenter of this crisis is not just the United States. We cannot help but see Japan as the likely epicenter of the most serious "neutral interest rate misreading shock."

 

For nearly 30 years, the Bank of Japan has continued to believe the narrative that "the neutral interest rate is near zero" and "Japan is destined for low growth and low inflation."

 

However, if neutral interest rates rise globally, Japan alone cannot maintain low interest rates.

 

Interest rates will inevitably be pushed up from the outside.

 

If the Bank of Japan were forced to raise interest rates by 2% cumulatively, the effective duration of Japanese stocks would be approximately 30 years.

 

In other words, the Nikkei average would sink from its current level of 50,000 yen to the 20,000 yen range.

 

This is not just a crash. It will test Japan's financial system, public finances, corporate management, and the people's very "faith in the future."

 

With this "neutral interest rate rebellion" at its core, a structural transformation of the Japanese and US economies and the reality Japan faces are inevitable.

 

However, a crash is not something to be feared. Rather, it should be seen as a "rite of passage" that exposes long-standing distortions and moves toward a new equilibrium.

 

The only way Japan can regain its future is to correctly understand and overcome this crash.

 

The only path to Japan's revival is to quickly normalize interest rates and, at the same time, permanently reduce the consumption tax rate to 5% and move toward "abolition of the consumption tax."

 

 

② "Irresponsible Active Fiscal Policy" Leads to Inflation Acceleration

--The Dangers of Simultaneous Expansion of Monetary Policy and the FY2026 Budget

 

A December 27th Nikkei editorial criticized the FY2026 budget as "the largest budget ever, lacking a perspective of responsibility." Their argument is generally valid, and I would like to add a few points.

 

■1. 11.5 Trillion Yen in Additional Spending from the FY26 Budget and Supplementary Budget

The FY2026 general account budget will be ¥122.3 trillion, an increase of ¥7.1 trillion from the previous year. Furthermore, the already enacted FY2025 supplementary budget is ¥18.3 trillion, an increase of ¥4.4 trillion from the previous year.

 

A total of ¥11.5 trillion in increased government spending (dG) will flow in all at once over the next year. Assuming a Keynesian fiscal multiplier of 1.5, the effect of boosting aggregate demand will amount to approximately ¥17.3 trillion. This corresponds to 2.6% of nominal GDP (¥665 trillion) for the July-September quarter of 2025.

 

In Japan, where the potential growth rate is only around 0.6%, this means that a net 2% of inflationary pressure will be added "through policy." In other words, while the Takaichi administration's expansionary fiscal policy is nominally "responsible fiscal policy," in reality it is nothing but an inflation-promoting policy.

 

■2. The Abnormality of Monetary Policy Continuing to Press the Gas at the Same Time

Meanwhile, there are no signs of monetary policy tightening.

• Inflation rate: around 3%

• Policy interest rate: 0.75%

• Long-term government bond purchases continue, albeit at a reduced rate (policy-based suppression of long-term interest rates)

This combination means that both short- and long-term real interest rates will remain negative.

 

As a result, monetary easing will continue on both sides:

• Interest rates

• A weak yen

• Fiscal and monetary policy will work together to stimulate aggregate demand.

 

■3. The Japanese Economy "Derails" Amid Quadruple Woes

Amid the fourfold worrisome effects of the national economy—a declining birthrate, long-term stagnant consumption, a weak currency, and high prices—fiscal and monetary policy are expanding simultaneously.

We are forced to warn that this policy mix will significantly deviate Japan from its original path of price stability and sustainable growth.

 

■4. Structural Problems Pointed Out in the Nikkei Editorial (Summary)

The Nikkei editorial points out the following issues: • The budget size is the largest ever for two consecutive years.

• Bond issuance remains unchanged despite increased tax revenue due to inflation.

• Political weakness, including support groups, the opposition party, and requests from the United States, is driving spending expansion.

• Many items, such as healthcare, education, defense, and fiscal investment and loan programs, are simply accepted.

• Rising government bond expenses are rapidly eroding fiscal flexibility.

• Relaxing the primary budget surplus target sends a negative signal to the market.

• Japan's government debt-to-GDP ratio is by far the worst among the G7 countries.

In particular, the sharp rise in long-term interest rates and the weakening of the yen following the passage of the supplementary budget should be interpreted as a warning from the market about Japan's fiscal management.

 

■5. What's Needed Now Is Not "Selection and Concentration," but "Redesigning the Policy Mix."

The current situation of simultaneous fiscal and monetary expansion is the exact opposite of a policy mix that will curb inflation.

• Fiscal policy: Selective and focused spending.

• Financial policy: A clear path to normalization.

• Growth strategy: Concentrate resources on raising the potential growth rate by permanently lowering the consumption tax rate to 5%.

Unless these three points are pursued simultaneously, Japan will face the worst possible combination of "inflation and stagnation."

 

 

③  Regarding the "Attack" Theory in the Tokyo Shimbun Editorial:

 

The "Speed ​​of Civilization" and "Faith in the Future" Beneath the Currency Crisis

 

The December 28th (Sunday) Tokyo Shimbun editorial reframed the currency crisis as an "attack" and described the financial market instability facing Japan in terms of a "shaking of confidence." This makes it a relatively structurally relevant issue compared to other recent editorials.

 

However, the contours of the crisis outlined in this editorial are actually rooted much deeper. It is not simply a matter of fiscal deficits or monetary easing, but rather concerns the more fundamental question of how much confidence civilization can maintain in the future.

 

1. "Attack" is a phenomenon, not a cause

 

The editorial points out the fact that the Ministry of Finance has been secretly preventing yen-selling attacks and points out the possibility that speculator attacks could destabilize the value of a nation's currency. This is a correct understanding from the perspective of the field in international finance.

 

However, it's important to note that attacks are a "result," not a "cause."

 

Speculators act when they discover structural distortions, such as currency overvaluation, doubts about fiscal sustainability, inconsistent interest rate policy, and political uncertainty.

 

In other words, attacks are merely the moment when a "speed asymmetry" deep within civilization surfaces.

 

2. Japan's vulnerability lies not only in its fiscal deficits but also in its "speed discrepancy."

 

The editorial sounds the alarm about fiscal deficits and MMT-like thinking, but that's not necessarily the fundamental problem.

 

The modern economic system has a "speed hierarchy" in which prices and wages adjust slowly, financial markets adjust quickly, currency markets adjust even faster, and expectations move at the speed of light.

 

The greater this discrepancy in speed becomes, the more likely the market will overshoot and overshoot.

 

Japan's vulnerability lies not only in its fiscal deficit, but also in the extreme widening of this speed asymmetry.

 

Prices are sluggish.

Wages are stagnant.

But the yen is plummeting.

Interest rates are soaring.

Expectations can change overnight.

This "fault line in velocity" is the essential breeding ground for attacks.

 

3. The editorial's omission: "Credibility of Civilization"

The editorial uses the word "credibility," but does not delve deeply into its meaning.

Credibility of a currency

is not simply about fiscal soundness or the size of foreign exchange reserves, but is related to a deeper dimension: how a civilization envisions the future.

Expectations for the future

Social sustainability

Political stability

Confidence in technological innovation

Outlook for the international order

When these are shaken, currencies are sure to fluctuate.

This is because currency is the most sensitive mirror that reflects how a civilization views the future.

 

4. Criticism of MMT is Valid, But the Discussion Is Still Shallow

The editorial sounds the alarm against the MMT-style "print money" approach, but the problem with MMT is not simply a lack of fiscal discipline. What MMT overlooks is the historical fact that the value of currency is supported by "faith in the future."

 

You can print money, but you cannot print faith in the future. As long as this perspective is missing, fiscal discussions will remain superficial.

 

5. Can Japan Reconstruct its "Future Narrative" for 2026?

The editorial concludes with a discussion of the "role of newspapers," but the real question is whether Japan can reconstruct its future narrative.

 

Currency

Interest rates

Government bonds

Financial affairs

Growth

Technology

International order

All of these are driven by how civilization imagines the future.

2026 will be the year to test whether Japan can regain that imagination.

 

◆ Summary: The editorial is a good starting point. However, it falls short of the essential points.

The Tokyo Shimbun editorial carefully describes the phenomenal crisis - attacks, confidence, fiscal deficits, and rising interest rates. However, it does not touch on the deeper aspects of the crisis, such as the "speed of civilization" and "trust in the future."

 

And this is precisely why the world is currently in turmoil. And it is this underlying structure that I would like to re-examine.

 

 

④ "Overshoot Model" and Memories of My Time at the World Bank and GWU: In Memory of the Late Professor Takatoshi Ito of Columbia University

 

One of my main recent themes of interest is the possibility that Japan's policy of devaluing its currency and impoverishing its neighbors (Abenomics, including the double-down Sanaenomics) could lead to a trade war, and ultimately to a war for hegemony and inflation due to the soaring price of precious metals (due to debasement trade, etc.), leading to the collapse of civilization that Lenin cursed as the end of capitalism.

 

After all, we live in an age where World War III is even possible.

 

By the way, the topic of my doctoral thesis at GWU while working at the World Bank in Washington, DC, was an overshoot model for Japanese and US stock prices.

 

The 1985 Plaza Accord, the 1987 Louvre Accord, and the Black Monday that began in New York shortly thereafter (1987). Furthermore, the expansion and collapse of the Heisei bubble, which followed the twin bubbles and their subsequent crashes after Black Monday.

 

I wondered whether I could describe the expansion and collapse of the stock bubble caused by US monetary easing, which led to a weaker dollar and a stronger yen, and the subsequent collapse of the stock market bubble, all of which were caused by fears of this, by applying an overshoot model based on a two-country Japan-US model.

 

There are two original ideas.

 

The first is the late MIT professor Dornbusch, who developed an exchange rate overshoot model (he would have been a sure winner of the Nobel Prize in Economics if he were still alive). Focusing on the price stickiness of goods and services markets and the flexibility of asset prices in interest rates and foreign exchange markets, the professor expressed exchange rate overshooting in a mathematical model using three simultaneous differential equations.

 

The other is a stock price overshoot model, developed by retired MIT professor Blanchard, who applied Dornbusch's exchange rate model to the stock market.

 

However, both are only single-country models.

 

So, using a two-country Japan-US model, I attempted to develop a model in which the Federal Reserve's monetary easing policy leads to an overshoot not only of the dollar-yen exchange rate, but also of Japanese stocks.

 

When I discussed this idea with Professor Koichi Hamada of Yale University in Washington, DC (I believe I was introduced to him by my superior, Makoto Sakurai (former member of the Bank of Japan's Policy Board), who was my mentor during my time at the Export-Import Bank of Japan's Overseas Investment Research Institute), Mr. Hamada had no knowledge of Blanchard's stock price overshoot model. I was surprised by this and, in fact, felt pleased, saying that the idea was novel and likely to make for an interesting doctoral thesis.

 

Also, Professor Takatoshi Ito of Columbia University, who sadly passed away this fall, was then one of the senior economists at the IMF's Institute for Monetary and Economic Studies, located just 19 Street away from the World Bank. When I was invited to the IMF cafeteria as a fellow university alumnus, I showed Mr. Ito the outline of my doctoral thesis proposal on exchange rate and stock price overshoot using a two-country model of Japan-US exchange rate and stock price overshoot. I have fond memories of him showing great interest and encouraging me. I would like to take this opportunity to express my heartfelt condolences to Mr. Ito.

 

Now, the famous Taylor model uses three simultaneous difference equations for the three variables of real GDP, interest rates, and inflation rates, and can easily be shown in Excel as an interest rate overshoot model.

 

This was first developed by Professor Ball of Johns Hopkins University, and although it is a single-country model, it can easily be applied to both the Japanese and US economies.

 

In this model, when a certain level of shock is applied to the goods and services market or the money market, real GDP, interest rates, and inflation rate all show large fluctuations.

 

Interest rates, in particular, are prone to overshooting.

 

Furthermore, an overshoot model for commodity prices such as gold and silver is thought to be excellent for describing the current debasement trade. In fact, this was already developed by Professor Frankel of the Harvard Kennedy School of Economics.

 

Both asset and commodity price overshoot models originated in the late 1970s and early 1980s, focusing on the difference between the stickiness of goods and services markets and the elasticity of other markets.

 

Incidentally, I remember making fun of the overshoot model in one of my books by saying it was like the story of "The Tortoise and the Hare" (laughs).

 

In retrospect, my metaphor for the overshoot model, like that of Aesop's fable "The Tortoise and the Hare," may have originally been a retelling of a conversation I had with Professor Hamada in Washington. Or maybe my memory is just fading.

 

In any case, the vicious cycle of currency war ⇒ trade war ⇒ hegemonic war (collapse of civilization) often leads to overshoots in interest rates, foreign exchange rates, stock prices, and commodities, making the economy uncontrollable.

 

The signs of hegemonic war and the collapse of civilization are already evident in these overshooting phenomena, and unfortunately, there is a sense of crisis that humanity, which is not exactly wise, may allow this collapse to occur.

 

With the New Year's holidays just around the corner, I am currently embarking on an ambitious publishing project both domestically and internationally. Stay tuned! (laughs)!

 

 

Former World Bank Economist

Tomo Nakamaru