For three decades, the Bank of Japan has been the quiet pioneer of unconventional monetary policy. It was one of the first major central banks to embrace zero interest rates, one of the first to adopt quantitative easing, and later one of the first to experiment with negative rates. Each time, the rest of the world watched with a mixture of curiosity and mild horror.
Over the past few years, the BoJ has again moved first—this time by sitting on its hands. Let me explain. Inflation accelerated, the long end of the Japanese government bond market sold off (interest rates went up), and the yen depreciated sharply. The result has not been chaos. In fact, it has been a meaningful improvement in Japan’s fiscal arithmetic.
Because the government continues to borrow at the short end—through shorter-maturity bonds—at rates below inflation, tax receipts have grown faster than the interest burden. Japan has clawed its way back toward a primary budget surplus. In other words, moderate inflation and a weaker currency have done some of the heavy lifting that fiscal austerity never quite managed. The broader point is not that Japan has found a painless solution. It is that high-debt governments often have an incentive to let inflation, nominal growth, and below-inflation funding costs do some of the adjustment work that politicians are unwilling to do directly.
That said, there is a legitimate counter-argument. The yen’s decline to multi-decade lows may not only reflect policy tolerance of a weaker currency. It may also reflect markets finally treating Japan’s heavy debt load as a big deal. Rising long-term yields, ambitious fiscal plans, and persistent capital outflows have all contributed to the pressure. The recent joint intervention by Japan and the United States to support the yen underscores this tension. Authorities on both sides became uncomfortable with the speed of the move, showing that there is a difference between orderly, policy-tolerated depreciation and a disorderly slide that forces official action. Intervention can slow the decline, but it does not resolve the underlying rate differentials or fiscal trajectory.
This strategy is not new
This approach has clear historical roots. After World War II, the United States and the United Kingdom faced debt-to-GDP ratios well above 100 percent—levels not far from where several major economies stand today. Both relied heavily on a combination of financial repression (keeping nominal interest rates artificially low through regulation and capital controls) and steady inflation. Real interest rates were negative for large stretches of the 1945–1980 period. In the United States and United Kingdom, this “liquidation effect” reduced the real debt burden by an estimated 3–4 percent of GDP per year on average. France, Australia, and Italy used similar tools with even larger effects in some years. The debt ratios fell dramatically without requiring brutal primary surpluses every single year.
Japan is running a modern version of the same playbook—minus the heavy capital controls of the Bretton Woods era, but with the same core ingredients: keep the short end low, allow the long end and the currency to adjust, and let moderate inflation plus nominal growth do the work.
A simple way to understand the concept is to think about a household with a large amount of debt and income that rises over time with inflation. If the interest cost on that debt rises more slowly than income, two helpful things happen at once:
- Monthly interest payments take a smaller bite out of rising income, and
- The real (inflation-adjusted) size of the debt shrinks over time.
The household does not necessarily need to make large extra payments for the burden to become more manageable. Japan is essentially running a version of this dynamic at the national level: the government is borrowing at relatively low short-term rates while inflation and nominal growth lift tax revenues and reduce the real weight of the existing debt.
Why the US and Europe might follow
The arithmetic facing the United States and Europe is not so different. Public debt levels are elevated, primary budget surpluses remain politically difficult, and aging populations are creating structural spending pressure. Central banks that talk tough on inflation still face strong incentives to avoid a sharp recession that would make the debt ratios look even worse. Elected officials, for their part, have little appetite for politically painful budget decisions.
Japan’s path offers the West a politically tempting path of least resistance. If Japan can manage a steeper yield curve alongside moderate inflation, investors should at least ask whether France, the United Kingdom, or the United States may tolerate something similar. Steeper curves can support bank net interest margins, which helps explain why bank stocks have outperformed local equity markets in many major regions. That outperformance is an encouraging signal, but it is not proof that the broader economy can absorb higher long-term rates without strain.
The special problem of the dollar
I have written before that the United States would benefit from a weaker dollar as part of any attempt to inflate away part of its debt burden and improve competitiveness. President Trump has said numerous times that he prefers a lower dollar, but in practice that has proven difficult. The dollar’s status as the world’s primary reserve currency is both a privilege and a constraint.
Because so much of the world’s trade, commodity pricing, and official reserves are denominated in dollars, aggressive or sustained dollar devaluation risks reducing foreign demand for Treasuries, pushing up U.S. borrowing costs, and importing inflation more quickly. Other countries can sometimes engineer a weaker currency with fewer global side effects. The United States cannot do so as freely without potentially eroding the very “exorbitant privilege” that allows it to run large deficits at relatively low cost. That is one reason the dollar has remained stubbornly strong even as U.S. fiscal metrics have deteriorated.
Japan faces a different constraint. The yen is not the global reserve currency, so yen weakness does not carry the same systemic risk as a deliberate dollar decline. But it still has domestic costs: it raises import prices, pressures consumers, and can become politically difficult if inflation outpaces wage growth. The point is not that Japan can weaken its currency without consequence, but that the consequences are more domestic than global.
Looking ahead
The Bank of Japan has shown that a high-debt advanced economy can tolerate moderate inflation, a steeper domestic yield curve, and a weaker currency without triggering an immediate crisis. Other major central banks facing similar debt arithmetic and similar political constraints on austerity may be tempted to take a comparable path. This path is not without risks. The recent intervention itself is a reminder that policymakers will act when currency moves become disorderly. Still, they may judge a controlled version of this approach less painful than aggressive tightening that risks recession, especially if inflation remains contained enough for households and markets to absorb.
For investors, the takeaway is not to assume that central banks will abandon inflation control altogether. It is to recognize that policy may remain more tolerant of moderate inflation than the old playbook would suggest. That kind of environment can favor nominal-growth beneficiaries, banks with improving net interest margins, companies with pricing power, and real assets, while creating ongoing risks for long-duration bonds and currencies exposed to fiscal stress.
Sometimes the most important policy signal is the decision not to act. By sitting on its hands for a long stretch, the Bank of Japan has demonstrated one workable path through high debt, moderate inflation, and a steeper yield curve. The joint intervention shows the practical limits of that approach. It will be interesting to see whether the United States and Europe ultimately choose a similar mix of tolerance and occasional intervention.
