Between 1995 and 2021, Japan’s average annual inflation rate was approximately 0.2%. For an entire generation, prices were essentially flat or falling. This was not a neutral condition. Deflation corroded the economy from the inside, suppressing wages, discouraging investment, rewarding cash hoarding, and keeping equity valuations perpetually depressed.

That era is over.

As of December 2025, Japan’s core consumer price index — excluding fresh food but including energy — had remained above the Bank of Japan’s 2% target for 45 consecutive months. The headline CPI averaged 3.2% for calendar year 2025, according to Japan’s Statistics Bureau. Even the “core-core” measure excluding both food and energy — the closest proxy for domestically generated inflation — has been running above 2% for over three years.

For investors evaluating Japan, understanding what this regime shift means is essential. It is the foundation upon which every other bullish argument rests.

Why Deflation Was So Destructive

To understand why the end of deflation matters, you first need to understand what it did to Japan.

In a deflationary environment, cash is king. If prices are falling, the rational behavior for every economic actor is to wait. Consumers delay purchases because goods will be cheaper tomorrow. Companies delay investment because demand is uncertain. Banks hoard capital because asset prices are declining. Workers accept stagnant wages because the cost of living is flat or falling.

This created what economists call a “deflationary equilibrium” — a stable but deeply suboptimal state where no individual actor has an incentive to change behavior, even though collective action would make everyone better off.

For equity investors, deflation was catastrophic. Nominal revenue growth was nearly impossible. Pricing power was nonexistent. Companies could only grow profits through cost-cutting, which eventually runs into limits. Valuations remained compressed because there was no nominal growth premium to justify higher multiples.

The Nikkei 225 peaked at nearly 39,000 in December 1989. It did not sustainably exceed that level until 2024 — a 35-year drought. The TOPIX told a similar story. No amount of corporate improvement could overcome the macro headwind of falling prices.

What Changed

The inflation regime shift was triggered by a combination of external shocks and structural changes.

The initial catalyst was imported inflation. Global supply chain disruptions during and after the pandemic, combined with yen weakness (the yen fell from roughly ¥110/$ in early 2022 to ¥150+ by late 2023), sharply increased the cost of energy and imported goods. Japan, as a major energy importer, was particularly exposed.

But imported inflation was merely the spark. What matters now is that domestically generated inflation has taken root, driven by three structural forces.

Wages are rising. The 2024 Shunto spring wage negotiations produced the largest wage increases in over 30 years. The 2025 round delivered nominal increases exceeding 5% at major companies. The Japan Center for Economic Research notes that the GDP output gap turned positive in the second quarter of 2025, meaning the economy is operating above potential — a condition that typically supports continued wage pressure.

Services inflation is broadening. While food and energy prices grabbed headlines, the more significant development is the gradual pass-through of higher wages into service sector prices. Hotel rates, restaurant prices, transportation fares, and communication services have all seen sustained increases. This is the inflation that sticks, because services are produced and consumed domestically — they cannot be easily substituted by imports and are not subject to commodity price swings. For the first time since the bubble era, Japanese companies across the service sector are successfully passing cost increases through to consumers.

Inflation expectations are shifting. After decades of expecting zero inflation, Japanese households and businesses are adjusting their expectations upward. This is self-reinforcing: when people expect prices to rise, they spend sooner rather than later, and companies gain the confidence to raise prices. Surveys of household inflation expectations have shown a persistent upward shift since 2022, and corporate pricing surveys indicate companies are increasingly willing to raise prices, with less fear of losing customers to competitors who hold the line. This behavioral shift is arguably the most important development of all, because expectations are what determine whether inflation becomes self-sustaining or fades once external shocks dissipate.

The Bank of Japan’s own assessment is cautious but directional. In its September 2025 Statement on Monetary Policy, the BOJ projected that underlying inflation would increase gradually as labor shortages intensify and medium-to-long-term inflation expectations rise.

The BOJ’s Careful Normalization

The Bank of Japan ended its negative interest rate policy in March 2024 and has since raised the policy rate to 0.5% as of January 2025. Governor Ueda has signaled willingness to raise rates further if economic conditions warrant, though the pace has been deliberately slow.

Even at 0.5%, real interest rates remain deeply negative — headline inflation of 2-3% minus a policy rate of 0.5% yields a real rate of roughly -1.5% to -2.5%. This means monetary policy is still highly accommodative in real terms, even as the direction of normalization is clear.

For equity markets, this is a favorable configuration. Moderate inflation supports nominal revenue growth, while negative real rates keep the cost of capital low and encourage risk-taking. The risk scenario — aggressive BOJ tightening that chokes off the recovery — appears unlikely given the government’s clear preference for accommodative conditions.

Prime Minister Takaichi has repeatedly emphasized proactive fiscal spending over fiscal austerity, and the interaction between fiscal expansion and monetary policy is a key dynamic. The BOJ faces a delicate balance between normalizing rates to maintain credibility and avoiding tightening that undermines the government’s growth agenda.

The market currently expects further rate increases later in 2026, potentially to 0.75-1.0%. This remains well below the BOJ’s estimated neutral rate range of 1.0-2.5%, suggesting significant runway for normalization before policy becomes genuinely restrictive.

Implications for Equity Valuations

The transition from deflation to moderate inflation has profound implications for how Japanese equities should be valued.

In a deflationary world, Japanese companies were valued on depressed nominal earnings with no growth premium. The appropriate price-to-earnings multiple for a company with zero revenue growth and limited pricing power is inherently low. This explained much of Japan’s persistent valuation discount to global peers.

In an inflationary world, nominal earnings grow even if real output is flat. A company that raises prices 3% per year and maintains volumes generates 3% nominal revenue growth mechanically. This justifies a higher earnings multiple because the future cash flow stream is growing in nominal terms.

The math is straightforward. If Japanese corporate revenue grows at 2-3% nominally from inflation alone, and if profit margins are stable or improving (driven by operating leverage and governance-driven cost discipline), then earnings growth of 5-8% annually is achievable even without market share gains or new business development. Add buyback-driven EPS accretion of 2-3% annually, and you arrive at double-digit EPS growth rates that are well above what most investors currently expect.

Daiwa Asset Management’s 2026 outlook estimates TOPIX could reach 3,750 by end of 2026 and 4,000 by end of 2027, implying potential price returns of 11% and 18% respectively from late 2025 levels. In an upside scenario where structural changes progress faster than anticipated, valuations could expand further.

The Wage-Price Spiral: Virtuous or Vicious?

A legitimate concern is whether Japan’s inflation could overshoot, becoming destabilizing rather than supportive. Rice prices, for example, surged dramatically in 2025, causing real consumer pain. Food inflation ran at 5-6% for much of the year.

However, several factors suggest the current inflation trajectory is more likely to settle into a sustainable 2-3% range than to spiral higher.

First, the energy component is volatile but mean-reverting. Government subsidies for electricity and gas introduced in late 2025 and early 2026 have already moderated energy inflation. The December 2025 CPI showed energy costs turning negative on a year-over-year basis.

Second, the Japan Center for Economic Research argues that the trend inflation rate — measured by CPI excluding food and energy — is considerably weaker than headline figures suggest, and may settle around the 2% level rather than accelerating further.

Third, the BOJ retains the tools to tighten policy if inflation genuinely overheats. Its cautious approach reflects appropriate prudence, not paralysis.

The Yen Factor

For foreign investors, Japan’s inflation story has an important currency dimension.

Higher Japanese inflation and BOJ rate normalization tend to support the yen, particularly relative to the US dollar. If the Federal Reserve cuts rates under incoming Chair Kevin Warsh while the BOJ continues to raise rates, the interest rate differential between the US and Japan narrows, supporting yen appreciation. Warsh, nominated by President Trump on January 30, 2026, is currently in favor of greater policy easing, driven by a view that productivity gains could boost US growth without driving higher inflation. If this plays out, the US-Japan rate gap could narrow significantly.

For foreign investors holding Japanese equities, yen appreciation is a double benefit: the underlying equity gains are amplified by currency gains when translated back to dollars, euros, or other home currencies. This is the mirror image of the yen depreciation that reduced foreign investor returns on Japanese assets during 2022-2023.

The yen’s recent trajectory, hovering near multi-decade lows against the dollar and briefly approaching 160 in early 2026, arguably makes the entry point for foreign investors particularly attractive. At these levels, even modest yen appreciation of 5-10% over the next year or two would add meaningfully to total returns.

Historical patterns also support this view. During previous episodes of BOJ policy normalization — albeit from different starting points — the yen tended to appreciate as carry trade attractiveness diminished and real return differentials shifted. While past patterns are not guarantees, the direction of the structural forces favoring yen recovery appears well established.

The currency tailwind may not materialize immediately, but over a multi-year horizon, the direction of travel seems clear. Investors who can tolerate short-term currency volatility may be well rewarded for maintaining unhedged exposure to Japanese equities.

What This Means for Portfolio Allocation

The end of deflation removes the most fundamental bear case that kept global investors underweight Japan for three decades. It does not guarantee outperformance — company selection, valuation discipline, and macro risks all still matter. But it transforms the baseline expectation.

In a world where Japanese companies can grow nominal revenues, maintain or expand margins, and simultaneously improve capital efficiency through governance reform, the case for a structural increase in Japan allocation is compelling.

Global index funds currently weight Japan at roughly 5-6% of the MSCI ACWI. For investors who believe the inflation regime shift is real and sustainable — and the evidence over 45 consecutive months above target is difficult to dismiss — this allocation likely understates Japan’s prospective returns relative to a global portfolio.

I am Hyottoko Sennin, a pen name. I have spent 30 years in Japan’s institutional investment industry and currently run a PIPE advisory firm in Tokyo. This article represents my personal views and does not constitute investment advice. Past performance does not guarantee future results. All investments involve risk, including the potential loss of principal. Please consult a qualified financial advisor before making investment decisions.