The International Monetary Fund has recommended that Japan continue to raise interest rates and avoid further loosening its fiscal policy. The warning comes amid concerns that a proposed cut to the national sales tax would weaken the country’s ability to respond to future economic downturns.
This advice arrives at a sensitive time, as the prime minister’s recent landslide election victory has increased market speculation about whether the government will push back against the central bank’s plans for further rate increases. The government has also pledged to suspend a planned 8% tax on food sales for two years.
The IMF stressed the importance of the central bank’s independence, stating it helps keep inflation expectations stable. It advised that monetary policy should continue its current course. “The central bank is appropriately withdrawing monetary accommodation, and gradual hikes should continue to move the policy rate toward a neutral level,” the IMF said in its preliminary recommendation.
Japan’s central bank ended a long-running stimulus program in 2024 and has raised interest rates several times since, most recently pushing its key rate to a 30-year high of 0.75%. With inflation remaining above the 2% target for nearly four years, the bank has signaled it is ready to keep tightening policy.
However, these higher borrowing costs could complicate the government’s plans for tax cuts and spending, which previously sparked a selloff in bonds and the yen over worries about the nation’s financial health.
The IMF specifically cautioned against reducing the consumption tax, warning it would “erode fiscal space and add to fiscal risks.” While making any tax cut temporary and limited to essential goods would help contain costs, the fund emphasized that overall fiscal restraint is necessary to maintain stability in the bond market. It called for a credible, medium-term plan to manage public finances.
The report highlighted that Japan’s high and persistent debt levels, along with a deteriorating fiscal balance, leave the economy vulnerable. It projected that interest payments on the national debt are set to double between 2025 and 2031 as older debt is refinanced at higher rates. Currently, a quarter of all government spending is funded by debt.
As the central bank reduces its bond purchases and shrinks its balance sheet, the IMF advised close monitoring of market liquidity. It suggested the bank should be prepared to make “exceptional targeted interventions,” such as emergency bond-buying, if market volatility becomes a problem.
Regarding the yen, the IMF welcomed the authorities’ commitment to a flexible exchange rate, stating that such flexibility helps the economy absorb external shocks and allows monetary policy to stay focused on controlling inflation.
