As Japan concluded its upper houseelection to the upper house of its parliament on July 20, the results stunned observers. The long-dominant ruling coalition of the Liberal Democratic Party (LDP) and its junior partner Komeito fell short of securing the 50 seats required to maintain their majority in the House of Councillors. Prime Minister Shigeru Ishiba, already struggling to command confidence amid economic malaise and a cost-of-living crisis, now faces a divided House of Councillors in the National Diet of Japan and calls for resignation from within his own party.

The LDP’s losses, while not catastrophic, have real consequences: Ishiba’s coalition now lacks a majority in both chambers of the National Diet. Meanwhile, traditional opposition parties such as the Constitutional Democratic Party (CDP) failed to capitalize on public discontent, making no net gains. Instead, the momentum was seized by the populist and nationalist right, with the Democratic Party for the People (DPFP) and Sanseitō emerging as the surprise victors of the night. The DPFP gained 13 seats, becoming the third-largest party in the upper house, while Sanseitō surged from one to 14 seats, riding a wave of anti-establishment frustration.

During the election period, the yen’s brief rally to ¥146.92 per dollar — sparked by unfounded speculation over US Federal Reserve Chairman Jerome Powell’s dismissal — quickly reversed as investor focus shifted back to Japan’s escalating political risks. By July 17, the currency had weakened to ¥148.48 per dollar, reflecting mounting expectations that Ishiba’s ruling coalition would lose its majority in the upper house in the July 20 election. 

Simultaneously, bond markets flashed warning signs: the 20-year Japanese Government Bond (JGB) yield surged 4.5 basis points to 2.650%, its highest since November 1999, while the 10-year yield climbed to 1.595%, the highest since October 2008. These moves signaled rising concern that the post-election government — potentially fragmented and under populist pressure — might turn to expansionary fiscal measures financed by increased bond issuance, reigniting doubts about Japan’s debt sustainability.

The International Monetary Fund’s (IMF) intervention highlights just how precarious the fiscal landscape has become. In a post-election environment marked by political fragmentation and heightened investor sensitivity, the IMF’s Director of the Communications Department, Julie Kozack’s, remarks serve as a warning shot. The IMF’s message is clear: Japan can no longer defer tough fiscal choices. With public debt already exceeding 250% of GDP, rising interest payments threaten to crowd out essential spending unless a credible consolidation path is laid out. The next government, regardless of its composition, will need to reconcile competing demands — supporting vulnerable households amid anemic growth while restoring medium-term fiscal discipline. Temporary, targeted stimulus may remain justifiable in the face of economic shocks, but the era of open-ended fiscal drift is drawing to a close.

“The risk of a sovereign downgrade is now quite high,” warned Mark Nash of Jupiter Asset Management, pointing to the projected jump in Japan’s interest payments as a share of revenues — from 9.9% last year to 12.2% this year. “If this is paired with aggressive tax cuts and little spending reform, we’re staring down the barrel of a ratings event.”

This election, long expected to be a routine midterm test, has instead triggered a reckoning across multiple fronts: fiscal credibility, central bank independence, voter discontent and sovereign creditworthiness. Japan’s 2025 upper house election has major financial implications,  as forces driving political change sharpen the fiscal policy dilemmas that the country’s fractured leadership.

Credit ratings, fiscal strain and the waning deflation buffer

Japan’s sovereign credit ratings remain officially “stable” across all three major agencies — Moody’s, S&P and Fitch — but the rhetoric surrounding them has turned increasingly cautionary. For example, Fitch’s Krisjanis Krustins has gone further. In public comments, he warned that “if Japan adopts tax cuts that are not offset by other policy measures and that don’t lead to much higher growth, basically that leads to higher fiscal deficits and an accelerated debt trajectory. That could certainly put pressure on the rating.” He specifically cited opposition-led proposals to permanently reduce or abolish the 10% consumption tax as particularly risky — policies that have become central to many populist platforms during the 2025 campaign cycle. 

Although Krustins acknowledged that implementation would likely be tempered by institutional resistance within a divided Diet, he emphasized the material risks posed by any fiscal loosening without clear productivity offsets. Fitch currently assigns Japan an “A’” rating — five notches below AAA — with a stable outlook, citing the country’s debt load, now approaching 250% of GDP, as the highest in the advanced world.

Moody’s Ratings said the potential impact of a consumption tax cut on Japan’s sovereign credit rating would depend on its “scope, magnitude and permanence.” Christian de Guzman, a senior vice president at Moody’s, noted that the ruling coalition’s weakened position may increase the likelihood of fiscal expansion. Still, it remains “sufficiently strong” to preempt sweeping tax changes. Ishiba has also reiterated his caution, warning that cutting the consumption tax could jeopardize funding for Japan’s rising social welfare costs. Japan’s A1 rating with a stable outlook has held since 2014, though Moody’s has warned that a sustained widening of fiscal deficits could lead to a downgrade.

This mounting concern reflects not merely headline fiscal aggregates but a deeper structural evolution in Japan’s macro-financial architecture. For decades, chronic deflation and near-zero interest rates allowed the Bank of Japan (BoJ) to absorb vast amounts of government debt with minimal market reprisal. That era is now receding. Core inflation has remained above 3% for more than six consecutive months. While it eased slightly to 3.3% in June from a 29-month high of 3.7% in May, largely due to the stabilization of rice prices following government stockpile releases, the persistence of elevated prices underscores a regime shift.

Significantly, the so-called “core-core” inflation rate — excluding both fresh food and energy — rose to 3.4%, its highest level since early 2023. The BoJ closely monitors this measure as a proxy for underlying demand-side inflation. Wage settlements have also reached their strongest levels in decades, and household inflation expectations have firmed — suggesting that the deflationary psychology that once dominated consumer and corporate behavior may be breaking down.

In response, BoJ’s exit from its long-standing regime of ultra-accommodative monetary policy has unfolded with measured precision. In March 2024, the BoJ formally ended its negative interest rate policy, raising the short-term policy rate to 0.0–0.1%, its first increase in 17 years. This move made it the final major central bank to abandon sub-zero rates. The decision marked a pivotal shift, not only in policy settings but also in the broader strategic posture of a central bank that had long been synonymous with aggressive easing.

July 2024 brought a second-rate hike, lifting the policy rate to 0.25%, the highest since 2008. This was followed by a third increase in January 2025 to 0.50%, a 17-year high. These steps reflected growing confidence among policymakers that Japan was nearing a durable exit from deflation, underpinned by accelerating wage growth, shifting corporate price-setting behavior and inflation that had persistently exceeded the BoJ’s 2% target for over three years.

Yet despite this momentum, the BoJ has since tempered its pace. At both the March and June 2025 policy meetings, the central bank opted to hold the rate steady at 0.50%, citing a confluence of downside risks. Chief among them: escalating US tariff measures, the uncertain trajectory of global trade negotiations and weakening external demand. These external headwinds, policymakers argue, complicate the domestic inflation picture — particularly as the BoJ continues to distinguish between headline inflation and underlying demand-driven pressures, which it still views as insufficiently robust.

This cautious recalibration has been reinforced by recent changes to the BoJ’s governing board. Kazuyuki Masu, newly appointed in July 2025, has advocated for restraint in the face of mounting geopolitical and macroeconomic uncertainties. At his inaugural press conference, he emphasized that while inflation expectations have risen, “real interest rates remain negative,” and “the BoJ shouldn’t be in a rush to raise rates.” He underscored concerns about unresolved trade tensions with the US — particularly around auto exports — and the unpredictable implications for Japan’s external sector.

Masu’s entry comes at a delicate juncture. The headline core consumer price index (CPI) has cooled to 3.3% in June,  down from a peak of 3.7% in May. This appears to have eased supply-side price pressures, such as elevated rice costs. though they remain well above historical norms. Meanwhile, core-core inflation, excluding both food and energy, edged up to 3.4%, suggesting that underlying inflation momentum is still present. The BoJ has signaled that further tightening remains on the table. Still, Governor Kazuo Ueda has indicated that any additional rate hikes will be contingent on sustained real wage growth and improved visibility around global demand conditions.

Together, these developments signal a central bank navigating a narrow path — balancing normalization against fragility, and inflation control against financial and geopolitical uncertainty. For now, the BoJ remains in wait-and-see mode, its forward guidance conditioned by a complex and evolving macroeconomic landscape.

Tariffs, the BoJ and the future of Japan’s fiscal path

The new US–Japan trade agreement marks a significant shift in the external pressures shaping Japan’s macroeconomic policy. By agreeing to a unified 15% tariff ceiling on automobiles, parts and selected industrial goods — down from the threatened 25% — Ishiba has temporarily averted a sharper shock to Japan’s export competitiveness. Yet the deal comes at a steep price: a promise of $550 billion in Japanese investment into the US economy, including increased purchases of American agricultural products, aircraft and defense equipment. 

While the Trump administration hails the agreement as a historic win, Japanese policymakers now face a complex trade-off. The concessions may reduce bilateral tensions, but they also raise new questions about fiscal sustainability, particularly as defense outlays and import spending increase in yen terms.

For the Bank of Japan, the deal complicates an already delicate normalization path. The central bank has signaled a cautious exit from yield curve control, but renewed import-driven inflation and potentially weaker external demand from tariff-altered supply chains could stall further tightening. Meanwhile, the political appetite for fiscal stimulus remains strong. With the ruling coalition weakened in the upper house and under pressure to respond to voter demands for relief, calls for consumption tax cuts and increased public spending are intensifying. 

However, as Moody’s and the IMF have recently warned, any sustained widening of deficits without credible fiscal consolidation risks a ratings downgrade. The post-election fiscal debate, now unfolding in the shadow of this US deal, will be a litmus test for Japan’s ability to balance geopolitical accommodation with macroeconomic discipline.

Populist economics and the erosion of orthodoxy

The economic grievances of Japan’s “working poor middle” (chūryū hinmin) — a class increasingly burdened by stagnant real wages, rising costs of living and thinning social protections — have reshaped the nation’s political discourse. Amid this pressure, populist economic appeals have gained traction across party lines, with tax cuts becoming the unifying banner. NHK polling reveals that ten of Japan’s 14 major political parties proposed some form of consumption tax reduction ahead of the 2024 general election. For a political system long dominated by technocratic moderation, this marked a populist inflection point.

This new popular ethos is captured in the voice of Noriyuki Hasegawa, a small business owner in Saitama: “We raised wages three times in two years, but raw materials and packaging costs are still eating our margins. We’re squeezed from all sides, and government support is just not reaching us.” His frustrations echo widely across Japan’s Small and Medium Enterprises (SMEs), which employ over 70% of the workforce yet remain underrepresented in policy design.

Perhaps most strikingly, this populist shift has placed Japan’s fiscal and monetary authorities under unprecedented scrutiny. The Ministry of Finance (MOF), long the bastion of budgetary orthodoxy, has become a public target. Demonstrators have gathered outside MOF headquarters to denounce what they call “bureaucratic austerity,” citing policies such as the “103万円の壁” (spousal tax deduction cap) as symbols of outdated governance. Viral campaigns depict the ministry as a cloistered institution prioritizing balance sheets over livelihoods. It describes this movement as a form of “material populism” — non-ideological but rooted in pervasive financial anxiety. 

These fiscal pressures have begun to spill into the monetary domain. In the LDP’s September 2024 leadership race, Sanae Takaichi — a leading candidate and Minister for Economic Security — directly challenged the BoJ’s policy normalization. “Frankly, it was too early,” she said at a televised debate, criticizing the BoJ’s July rate hike to 0.25%. On her personal YouTube channel, she went further, arguing that ultra-low interest rates must be maintained to support a fragile recovery. “Interest rates ought to be kept low,” she declared, signaling a growing willingness among politicians to challenge central bank autonomy in the name of growth and electoral responsiveness.

Ueda, by contrast, has signaled a cautious commitment to further tightening if Japan sustains 2% inflation alongside real wage growth. Yet that technocratic stance may prove politically untenable. If Takaichi — or another pro-stimulus leader — ascends to power, Japan could see monetary policy increasingly subordinated to political will. In that scenario, central bank independence, once a cornerstone of Japan’s post-bubble policy credibility, may quietly erode under the weight of populist economic realignment.

Enter Sanseitōand the rise of the online populist right

No party embodied the populist wave more than Sanseitō. Founded during the pandemic with a fringe anti-vaccine message, the party won a stunning 14 seats in the upper house, up from just one. It did so with a mix of nationalist rhetoric, savvy social media mobilization and economic promises tailored to working-class voters: consumption tax cuts, child benefits and “Japanese First” policies opposing immigration.

Its leader, Sohei Kamiya — a former LDP candidate — has emerged as a charismatic (if polarizing) political force. Like many populists, Kamiya thrives on outrage. He has decried globalism, gender equality and foreign investment in Japanese land. Yet his message resonates, particularly among men aged 20 to 50.

Sanseitō’s rise has already forced policy recalibrations. Days before the election, the LDP rushed to establish a new committee on immigration — a tacit acknowledgement of the party’s vulnerability on that front. And while Sanseitō still lacks the seats to influence budget legislation, its presence will shape the rhetorical and ideological contours of future debates.

Sanseitō, a relatively new but vocal populist party, has positioned itself as a critic of both fiscal orthodoxy and elite policymaking. Its budget policy emphasizes aggressive fiscal expansion — calling for the abolition of the consumption tax, large-scale direct transfers to households and increased domestic investment without regard to debt sustainability. 

Rejecting the Ministry of Finance’s long-standing emphasis on fiscal discipline, Sanseitō argues that Japan’s monetary sovereignty allows for expansive deficit financing under a “national interest first” paradigm. Critics warn that such proposals risk undermining long-term fiscal stability, but the party’s message resonates with segments of the electorate who feel excluded from Japan’s post-COVID recovery and disillusioned with technocratic governance.

Takaichi’s fiscal vision: Proactive stimulus in an era of constraint

Among Japan’s leading political figures, Takaichi has consistently advocated for proactive fiscal stimulus, arguing that Japan’s persistent output gap and demographic headwinds require bold public investment rather than premature consolidation. While critics warn of mounting debt sustainability risks, Takaichi frames fiscal expansion not as a reckless departure from orthodoxy, but as a necessary adaptation to Japan’s unique macroeconomic conditions — namely, subdued private demand, structurally low inflation and an aging society that demands both care infrastructure and economic revitalization.

Her policy proposals include large-scale infrastructure programs, enhanced child and family support and strategic reindustrialization measures — all underpinned by the view that public spending can crowd in private investment if deployed effectively. In the post-election policy vacuum, her stance is gaining renewed attention, especially as voters demand economic relief and the US trade deal adds new spending pressures. 

Whether her fiscal philosophy will gain institutional traction remains to be seen, but it now shapes a key axis of debate within Japan’s shifting political economy. While Takaichi’s approach offers short-term political and economic relief, it raises profound questions about the timing, credibility and coordination of Japan’s return to fiscal sustainability.

The global reverberations of Japan’s macro shift

Japan’s monetary inflection point is sending ripples far beyond its archipelago. As the single largest foreign holder of US Treasury securities — owning over $1.3 trillion as of mid-2025, according to US Treasury data — Japanese institutional investors wield significant influence over global capital flows. The BoJ’s gradual retreat from yield curve control (YCC) and the normalization of its monetary stance have intensified linkages between Japanese Government Bond (JGB) yields and US Treasury rates. Analysts at Bloomberg have documented a marked rise in cross-border yield correlations, signaling a deeper integration of Japan’s bond market into global financial dynamics.

Should the JGB market come under sustained selling pressure — as investors price in higher domestic yields and a steeper curve — Japanese insurers, banks and pension funds may face strong incentives to reduce their exposure to foreign debt and repatriate funds. This capital rotation would exert upward pressure on US long-end yields at a delicate moment for the Federal Reserve, which is navigating disinflation, elevated deficits and tightening financial conditions. Even modest shifts in Japanese allocation preferences can affect global term premia (the additional compensation investors demand for holding longer-term bonds compared to shorter-term bonds), particularly given the scale of Japanese holdings in global fixed income markets.

The broader implication is clear: Japan’s internal policy debate — once a technocratic affair insulated from global attention — has become a key driver of international market volatility. As populist forces like Sanseitō call for aggressive fiscal expansion and challenge long-standing economic orthodoxy, political pressure on the BoJ is intensifying. 

Even within the ruling coalition, figures such as Sanae Takaichi have openly criticized the BoJ’s rate hikes, signaling a growing willingness to subordinate monetary policy to political imperatives. This erosion of central bank independence raises serious concerns for investors, who are increasingly demanding a risk premium on JGBs. As the BoJ navigates its exit from ultra-accommodation, it is no longer just resetting domestic conditions — it is exporting uncertainty through bond markets, currency channels and global rate correlations.

Populism or prudence

Japan’s 2025 upper house election has reshuffled the political deck — but not resolved the underlying tensions. Voters delivered a clear message: they want relief from economic hardship, skepticism toward the establishment and new voices in the policymaking arena. But translating that message into coherent governance will be difficult.

It might also accelerate the drift toward fiscal populism. Tax cuts, expanded social spending, and delayed reforms are politically seductive but economically perilous.

The most dangerous outcome is fiscal dominance: a regime in which public debt constraints dictate monetary policy, undermining inflation control and financial stability. Reinhart and Rogoff warned of this in their post-crisis research. Japan avoided it for decades. It may not be so lucky this time.

For now, the bond market is issuing a warning, not a verdict. But the window for credible policy response is narrowing. To restore confidence, Japan’s next government must articulate a clear fiscal roadmap — one that addresses legitimate, popular concerns without sacrificing macroeconomic discipline. That is a tall order, but the alternative is far worse.

[Kaitlyn Diana edited this piece]

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.