The Bank of Japan (BOJ) signaled optimism about the Japanese economy on Thursday, citing gradual recovery in regional economies and the continued expectation of wage growth among firms in fiscal 2026. At the same time, escalating tensions with China present a potential risk to Japan’s fragile economic recovery.

Wage Growth and Inflation Outlook

According to a survey of the BOJ’s regional branch managers, many companies in Japan plan to continue raising wages in 2026 at similar rates to 2025, driven by a tight labor market and high corporate profits. Firms are also passing on higher input, labor, and distribution costs through price increases, in part due to a weaker yen, which has raised import costs.

“While some regions said exports and output were weakening due to higher U.S. tariffs and rising competition from Asian companies, other firms are enjoying strong orders, particularly for goods related to artificial intelligence,” the BOJ report noted.

The central bank views these trends as evidence of a cycle of rising wages and inflation, potentially justifying further interest rate increases.

Regional Economic Recovery

The BOJ’s report emphasized a moderate recovery across all nine regional areas compared with three months ago, with economies picking up gradually. Officials maintain that, while some sectors are experiencing slower growth, others are benefiting from increasing global demand.

Hiroshi Kamiguchi, head of the BOJ’s Nagoya branch, said:

“We haven’t heard of any severe damage so far. But a wide range of manufacturers and non-manufacturers say the impact could appear ahead. Japan and China have close supply chain ties, so some firms see the impact of China’s export restrictions as potentially affecting their businesses.”

Impact of China Tensions

Escalating political tensions with China, including restrictions on travel to Japan following comments by the Japanese Prime Minister about Taiwan, have had limited immediate impact, according to the BOJ survey. Some hotels and retailers reported reduced sales from group tourism from China, though these declines were largely offset by visitors from other countries.

Nevertheless, some central bank executives warned that the economic impact could broaden over time, particularly through supply chain disruptions.

Interest Rates and the Weak Yen

In December, the BOJ raised its policy rate to 0.75% from 0.5%, marking the highest level in 30 years and a further step in ending decades of ultra-loose monetary policy. Despite this, Japan’s real borrowing costs remain deeply negative, as consumer inflation has exceeded the BOJ’s 2% target for nearly four years.

Kazuhiro Masaki, BOJ Osaka branch manager, highlighted that companies in western Japan are adjusting to higher borrowing costs, noting that three years of steady wage gains and rising inflation have changed the economic landscape:

“The situation has changed dramatically from the time Japan was suffering from deflation, with wages and prices barely rising.”

Some BOJ board members also expressed concern that a weak yen could further fuel inflation by pushing up the cost of imported goods.

Next Policy Review

The BOJ will review its quarterly growth and inflation outlook at its next policy meeting on January 22-23, 2026. Many analysts expect the central bank to maintain its current rates for now, given ongoing wage growth, persistent inflation, and geopolitical uncertainties.