Takaichi Cabinet’s Tax Cuts Fuel Yen Weakness, Making a Rate Hike Inevitable by Year-End

Cutting the food consumption tax to 1% to create an annual revenue shortfall of $29.9 billion
Yen-selling pressure fueled by fiscal instability and rising government bond yields
BOJ tightening bias intensifies as yen weakness drives up import prices

The Bank of Japan (BOJ) held its benchmark interest rate at 1.0%, while Governor Kazuo Ueda signaled the possibility of further rate increases at or after its next meeting in September. A hold had been widely expected because the BOJ had only raised the rate from 0.75% to 1% in June, but the policy environment shifted sharply after Prime Minister Sanae Takaichi formally unveiled a plan to cut the food consumption tax rate from 8% to 1%. The expansionary fiscal policy would create an annual revenue shortfall of $29.9 billion, potentially increasing government bond issuance and refinancing burdens while intensifying selling pressure on the yen.

Ueda Signals Faster Pace of Rate Hikes

According to NHK on Aug. 3, the BOJ decided at its monetary policy meeting held on July 30–31 to maintain its short-term policy rate at 1%. Eight of the nine Policy Board members, including Governor Ueda, voted in favor of the hold, while board member Hajime Takata dissented and called for another rate increase. The BOJ had raised the rate from 0.75% to 1% the previous month, and its latest decision was widely interpreted as a move to defer further tightening while assessing the impact of that increase on the economy and inflation.

Market attention focused less on the decision itself than on Ueda’s remarks at the subsequent news conference. “If we judge that financial conditions remain accommodative, we may accelerate the pace of interest rate increases,” Ueda said. His remarks were interpreted as a signal that the BOJ would not postpone another increase for an extended period merely because it had recently raised rates. “Depending on economic activity, prices and financial conditions, we will continue raising the policy rate and adjusting the degree of monetary accommodation,” he added. Ueda said the timing and pace of further increases would be determined through a comprehensive assessment of developments in the Middle East, expanding demand related to artificial intelligence (AI) and exchange-rate movements.

Ueda also identified exchange-rate fluctuations as a major policy variable. “The impact of exchange-rate movements on prices may be greater than it was in the past,” he said. He noted that the yen had depreciated substantially over the past year while underlying inflation was approaching 2%. Unlike in earlier periods when inflation remained well below the BOJ’s target, policymakers must now guard against the risk that yen weakness will push import prices higher and place additional upward pressure on consumer prices.

Ueda expressed particular concern that underlying inflation could exceed the BOJ’s 2% target, warning that a delayed policy response could allow upside risks to inflation to materialize and subsequently damage the Japanese economy. “It is important to stabilize inflation at around 2%,” he said. “If we judge financial conditions to be excessively accommodative, accelerating the pace of interest rate increases is also an option.” His comments suggested that the BOJ could raise rates more rapidly than the roughly once-every-six-months pace currently anticipated by markets.

Food Consumption Tax Cut From 8% to 1%

The Takaichi administration’s tax-cut proposal is the factor most likely to complicate the BOJ’s monetary policy trajectory. On July 30, Takaichi told an extraordinary meeting of Liberal Democratic Party executives that the food consumption tax would be reduced to 1% for two years beginning next April. Middle- and lower-income households would also receive cash-equivalent assistance corresponding to the remaining 1% tax, effectively reducing their food consumption tax burden to zero. The Japanese government plans to consolidate views within the ruling party early next month, approve the policy at a Cabinet meeting and submit the relevant legislation to an extraordinary Diet session in the fall. If implemented, it would be Japan’s first consumption tax rate cut since the levy was introduced in 1989.

Earlier this year, the Liberal Democratic Party pledged during the House of Representatives election campaign to reduce the food consumption tax to zero for two years. However, after considering that retailers could require up to a year to overhaul their point-of-sale systems, the party revised the proposal to a 1% rate that could be implemented sooner. The retail industry estimates that adapting its systems to a 1% rate would take five to six months.

The Japanese government intends to use the consumption tax cut to revive consumer sentiment, which has been dampened by elevated inflation. Citing private-sector economic research institutes, the Nikkei reported that “reducing the food consumption tax to 1% would lower the consumer price index by 1 to 1.4 percentage points in fiscal 2027,” which runs from April 2027 through March 2028. The Takaichi administration also calculates that the proposal would limit the loss of tax revenue compared with a complete exemption.

Nevertheless, the resulting revenue shortfall is estimated at $29.9 billion annually. Japan’s fiscal 2026 budget amounts to $779.7 billion, roughly one-quarter of which is financed through government bond issuance. Consumption tax receipts account for approximately 22% of total tax revenue. With social security spending continuing to rise as the population ages, reducing a stable source of revenue would inevitably increase uncertainty surrounding the government’s long-term fiscal management.

Takaichi has said the government would secure the necessary funding without issuing additional deficit-financing bonds, instead relying on non-tax revenue generated by sovereign funds and foreign-exchange assets, expenditure restructuring and higher tax receipts resulting from nominal economic growth. Markets, however, responded skeptically. On July 30, when details of the tax-cut plan emerged, the yield on Japan’s 10-year government bond rose 5.5 basis points to 2.8%. The move reflected concerns that the revenue shortfall created by the tax cut could ultimately result in additional government bond issuance and higher refinancing costs.

Table 1. Drivers of Prolonged Yen Weakness and Potential Exchange-Rate Reversal Triggers

Yen Continues to Slide Despite Rate Increases

Concerns are also mounting that a prolonged dispute over financing the tax cut could drive government bond yields higher, pushing bond prices lower, while further weakening the yen. Yen depreciation is currently the most serious problem facing the Japanese economy. In the early 2010s, the dollar-yen exchange rate hovered around 100. At the time, the prevailing belief was that a weaker yen acted as a tailwind for Japan’s export-oriented economy. The second administration of Shinzo Abe, which took office in late 2012, encouraged yen depreciation through what it called monetary easing “of a different dimension.”

When the Takaichi government took office last year, the dollar-yen exchange rate was in the upper 140s, but it has recently become entrenched in the 160 range. While yen weakness has boosted profits at large exporters and lifted equity prices, workers’ real wages have barely increased. The mechanism through which corporate profits were redistributed across society has broken down. Instead, Japanese households, which depend heavily on imported food and energy, have faced worsening financial hardship as the weaker yen drives up prices.

The yen’s depreciation has accelerated further this year because of waning confidence in Japan’s economy and public finances. Outstanding government debt slightly exceeds $8.15 trillion, equivalent to roughly two years of Japan’s gross domestic product (GDP). Although the population is shrinking and social security expenditure is rising, the contraction of the labor force is eroding the economy’s capacity to generate income. Even the automotive industry, historically a pillar of Japan’s trade surplus, is struggling after falling behind in electric vehicles. These conditions have fueled warnings that Japan could soon lose its standing as an advanced economy. Some economists are forecasting a dollar-yen exchange rate of 200.

Positioning data provide the basis for such a sharp-reversal scenario. Foreign-exchange market participants have noted that the current market imbalance resembles conditions immediately preceding the “Reiwa Black Monday” of summer 2024. The dollar-yen exchange rate peaked at 161.96 on July 3, 2024, before government intervention, a BOJ rate increase and weaker U.S. employment data converged to drive it vertically downward into the 141 range amid the Aug. 5 crash. The unwinding of yen carry trades subsequently spread into a sharp selloff in U.S. technology stocks.

Current positioning data are also approaching those levels. According to the Nikkei, CFTC data showed that speculative investors in the non-commercial category held a net short yen position of 155,092 contracts as of June 30, the largest since the 182,033-contract position recorded immediately before the July 2024 intervention. The total was 1.5 times the 102,059 contracts recorded immediately before the intervention in late April this year. Among hedge funds, positioning has already reached historic levels. Bloomberg data show that leveraged traders held short yen positions totaling 138,000 contracts on the same date, the largest in 19 years since June 2007, when the yen carry trade peaked at 154,000 contracts. If authorities pull the trigger, forced liquidation of these positions could unleash a violent exchange-rate reversal, making the current imbalance a ticking time bomb.

Yen Weakness Intensifies Export Competition

Moreover, yen depreciation is worsening Japan’s import-price and real-wage problems while directly altering the competitive landscape for exports from South Korea and China. South Korea, whose export portfolio overlaps with Japan’s in industries such as chemicals and electronics, becomes increasingly disadvantaged in price competitiveness as the yen weakens. China likewise has greater incentive to slow the pace of appreciation in its currency or support price reductions by exporters in response to the falling dollar-denominated prices of Japanese products.

South Korean and Chinese authorities are currently prioritizing efforts to curb precipitous declines in their currencies. On July 30, South Korean foreign-exchange authorities sold dollars and purchased the domestic currency during the same period in which Japan was buying yen. Because movements in the South Korean currency and the yen are closely correlated, allowing the yen to plunge unchecked could spread speculative selling to both the South Korean and Chinese currencies. China has allowed its currency to appreciate gradually against the dollar, but its real effective exchange rate remains low. China’s real effective exchange rate declined 2.4% in 2025 and remains 17% below its March 2022 peak. China’s low inflation, weak domestic demand and manufacturing overcapacity are depressing export prices, and their interaction with yen weakness could further intensify price competition among Asian exporters.

If major Asian currencies resume their decline, the U.S. goods trade deficit is also likely to widen. As the dollar-denominated prices of Japanese, South Korean and Chinese products fall, U.S. companies face mounting price pressure in both their home market and third-country markets. This explains why the U.S. Treasury placed all three countries on its monitoring list in last month’s foreign-exchange report and warned that unfair currency practices were placing additional strain on the U.S. trade deficit and manufacturing employment. The U.S. current account is also determined by domestic savings and investment as well as the services and income balances. Nevertheless, if the currencies of all three countries—which maintain large trade surpluses with the United States—depreciate simultaneously, the U.S. government is likely to intensify its trade pressure.

U.S. Sells Euros and Buys Yen

The U.S. Treasury’s actions demonstrate how sensitively Washington views yen depreciation. On July 31, the Treasury sold euros and purchased yen through the Federal Reserve Bank of New York. U.S. authorities effectively joined the yen-buying operation as the Japanese government and the BOJ sold dollars and purchased yen. Washington also moved aggressively to warn markets in addition to conducting actual transactions. On July 31, the Treasury notified multiple banks in advance that “yen-buying intervention may take place today.” A day earlier, it conducted a “rate check,” which is widely regarded as a preliminary step toward intervention. The exceptionally rare move was intended to deter speculative yen selling by signaling to markets that the United States was fully supporting Japan’s efforts to defend its currency.

U.S. interests also underpin Washington’s active support for Japan’s defense of the yen. If broad-based selling of Japanese assets drives down both the yen and Japanese government bond prices, Japanese financial institutions and institutional investors could begin liquidating their holdings of U.S. Treasuries. Citigroup warned that Japanese investors could sell as much as $130 billion in U.S. Treasuries following the rise in Japanese interest rates in January. Japan remains the largest foreign holder of U.S. government debt, but its holdings fell by $66.7 billion in May from the previous month to $1.1143 trillion—the largest decline among all countries.

The United States can ill afford to ignore the risk of broader U.S. Treasury selling by Japanese investors. The yield on the 10-year U.S. Treasury has recently climbed into the 4.7% range, while the 30-year yield has reached the 5.2% range, its highest level in 19 years. With U.S. federal debt approaching $40 trillion and annual interest expenses reaching $1 trillion, additional government bond selling could increase both U.S. borrowing costs and the federal government’s fiscal burden.