PUBLISHED June 28, 2026
Growth Set to Ease as the Middle East Weighs on the Outlook
According to the OECD’s Economic Survey of Japan 2026, launched on 13 May 2026, after growth of 1.2% in 2025, GDP growth is expected to ease to 0.7% in 2026 and 0.9% in 2027, in the context of rising energy prices and near-term uncertainty due to the conflict in the Middle East. Inflation is projected to be 2.0% in 2026 and 1.9% in 2027 — sitting at or near the Bank of Japan’s target, a notable milestone for an economy that spent decades struggling against deflation rather than fighting to contain rising prices.
A New Equilibrium of Higher Prices and Wages
Japan’s economy has demonstrated resilience despite global headwinds, with growth projected to continue at a moderate pace supported by domestic demand. As Japan transitions toward a new equilibrium of higher prices and wages, macroeconomic policies must be carefully calibrated to balance maintaining inflation near the 2% target, securing fiscal sustainability, and fostering long-term growth in an ageing society. This represents a genuine structural shift for an economy long defined by stagnant wages and prices, and the OECD frames the current moment as a critical window for locking in the transition durably rather than slipping back into deflationary habits.
The Highest Debt Burden in the OECD
The scale of Japan’s fiscal challenge is striking: gross public debt is the highest in the OECD, at around 206% of GDP in 2024. Rising debt servicing costs highlight the importance of placing public debt on a downward path by addressing ageing-related spending pressures, increasing tax revenues, and limiting reliance on supplementary budgets. The number of elderly as a share of the working-age population is set to reach 79% by 2060, meaning ageing and debt servicing costs are both projected to keep rising through 2050 even before accounting for additional spending commitments on green and digital transformation, defence, and economic security.
The ensuing steps toward monetary policy normalisation — increases in the policy interest rate alongside a reduction in Bank of Japan purchases of government bonds — create both opportunities and challenges. Higher interest rates can improve financial market functioning and resource allocation, boosting productivity growth, including by facilitating the exit of low-productivity firms, and can also increase bank profitability. However, a disproportionate increase in bankruptcies could hurt bank balance sheets, while higher rates will also increase the government’s debt servicing costs in nominal terms given the already elevated debt-to-GDP ratio — a tension that requires fiscal policy to remain prudent precisely as the investor base for Japanese government bonds needs to broaden.
The ensuing steps toward monetary policy normalisation — increases in the policy interest rate alongside a reduction in Bank of Japan purchases of government bonds — create both opportunities and challenges. Higher interest rates can improve financial market functioning and resource allocation, boosting productivity growth, including by facilitating the exit of low-productivity firms, and can also increase bank profitability. However, a disproportionate increase in bankruptcies could hurt bank balance sheets, while higher rates will also increase the government’s debt servicing costs in nominal terms given the already elevated debt-to-GDP ratio — a tension that requires fiscal policy to remain prudent precisely as the investor base for Japanese government bonds needs to broaden.
The fiscal stance is projected to be expansionary in 2026, following 2025 tax reforms and additional energy subsidies. In the absence of supplementary budgets, fiscal policy will tighten in 2027. Given rising interest rates, elaborating a clear and credible medium-term fiscal consolidation plan — underpinned by specific expenditure and tax measures — is needed to secure medium-term fiscal sustainability. The OECD argues this needs to start with curbing spending growth through pension, health, and long-term care reforms, recognising that these areas represent the structural drivers of Japan’s fiscal pressure rather than temporary or cyclical factors.
In the context of a shrinking working-age population, boosting productivity and labour supply are needed to sustain living standards. Boosting productivity hinges on revitalising business dynamism, enhancing innovation spillovers, attracting more foreign capital, and fully harnessing digitalisation. The OECD’s accompanying chapter on procurement reform highlights one concrete lever: the share of non-competitive government contracts has risen markedly to 62% in fiscal year 2023, though excluding defence-related items — which have jumped recently — brings that figure down to 34%, suggesting genuine room remains to strengthen competitive procurement practices that could otherwise drive innovation and efficiency gains.
While increased uncertainty due to the evolving conflict in the Middle East creates challenges, the gradual withdrawal of monetary accommodation should be continued, given robust wage growth and projected inflation around the 2% target. This recommendation predates, but aligns closely with, the Bank of Japan’s actual June 2026 decision to lift its policy rate to 1% — its highest level since 1995 — suggesting the central bank’s recent tightening path sits squarely within the trajectory the OECD considers appropriate for an economy navigating its long-awaited exit from deflation.
The fiscal stance is projected to be expansionary in 2026, following 2025 tax reforms and additional energy subsidies. In the absence of supplementary budgets, fiscal policy will tighten in 2027. Given rising interest rates, elaborating a clear and credible medium-term fiscal consolidation plan — underpinned by specific expenditure and tax measures — is needed to secure medium-term fiscal sustainability. The OECD argues this needs to start with curbing spending growth through pension, health, and long-term care reforms, recognising that these areas represent the structural drivers of Japan’s fiscal pressure rather than temporary or cyclical factors.
In the context of a shrinking working-age population, boosting productivity and labour supply are needed to sustain living standards. Boosting productivity hinges on revitalising business dynamism, enhancing innovation spillovers, attracting more foreign capital, and fully harnessing digitalisation. The OECD’s accompanying chapter on procurement reform highlights one concrete lever: the share of non-competitive government contracts has risen markedly to 62% in fiscal year 2023, though excluding defence-related items — which have jumped recently — brings that figure down to 34%, suggesting genuine room remains to strengthen competitive procurement practices that could otherwise drive innovation and efficiency gains.
While increased uncertainty due to the evolving conflict in the Middle East creates challenges, the gradual withdrawal of monetary accommodation should be continued, given robust wage growth and projected inflation around the 2% target. This recommendation predates, but aligns closely with, the Bank of Japan’s actual June 2026 decision to lift its policy rate to 1% — its highest level since 1995 — suggesting the central bank’s recent tightening path sits squarely within the trajectory the OECD considers appropriate for an economy navigating its long-awaited exit from deflation.
