News & Insights

Depopulating Japan Suddenly Faces an Inflationary Future

Japan became a case study of a developed nation with a rapidly aging population and deflation, with its modern monetary theory response unable to stimulate growth. Japan suddenly is struggling to get inflation under control, challenging the conventional wisdom about the economic effect of significant population decline, perhaps foreshadowing the path of other developed economies. The Bank of Japan, under its new governor, is contending with a core inflation rate of 3.3%, higher than the United States.

For years, Japan has avoided the consequences of a decline in labor supply as more women and older workers entered the workforce. Government policies encouraged rising labor force participation, suppressing the effect of a declining labor supply: wage inflation. That policy may have reached its limits as the population of Japan fell by 908,000 last year, the largest drop since records began in 1968. Fewer workers are translating into higher labor costs — union negotiations are producing the largest wage hikes in 34 years.

Shrinking workforces pose a challenge for developed economies worldwide. Europe is facing similar trends, and even the United States, with its somewhat healthier demographics and more robust immigration, cannot ignore the implications. This is exacerbated by the global tailwinds of cheap Chinese goods and low interest rates ebbing.

Japan’s government is desperate for productivity gains from AI and robotics to offset demographic decline. The fight is a precursor of what faces the developed world. American technology leadership and massive capital spending may be an advantage in this new economic and demographic era.

Japan’s newly elected right-leaning prime minister has embraced fiscal stimulus even as Japan’s gross debt-to-GDP ratio sits above 200%, the highest in the developed world. Yields on the 30-year government bond have risen over 100 basis points in the past year as investors worry about the sustainability of Japan’s fiscal burden.

Developments In Wages and Prices In Japan

Source: Ministry of Internal Affairs and Communication, Japanese Trade Union Confederation, Central Labour Relations Commission

Japan 30-Year Government Bond Yield

Source: Bloomberg

Struggling Small Businesses

American small businesses have faced uncertainty, tariffs, inflation and lackluster foot traffic. Although “soft” (expectation-based) data remains strong, any uptick in “hard” data has been elusive. However, recent hard data points to modest improvement.

In the face of a government shutdown, earnings fell this month after hitting a three-year high, though they are still up year-over-year. Sales have followed a similar path.

The recovery for small businesses has been uneven, with uncertainty high, particularly for small importers still exposed to the risk of new global tariffs. While overall capital expenditures have been buoyed by big tech companies’ AI and software boom, small firms’ capital expenditures haven’t rebounded because they lack resources. Small companies stand to be next stage beneficiaries of AI development.

Business owners’ expectations of increasing labor compensation have moderated, but they are still high by historical standards, reflecting persistent job market tightness. The biggest problem for small businesses, finding quality employees, worsened significantly last month. Insurance costs are a significant expense, outpacing even regulatory burdens. Small business distress is reflected in a shrinking of its share of overall job growth, now at an all-time low, despite the pandemic-era spike in new small business formation.

The outlook for 2026 may be improving. In addition to the stimulatory effects of Federal Reserve interest rate cuts, small businesses will benefit from deregulation and tax relief.

Small Business Optimism

Source: Bloomberg

Small Business Survey “Most Important Problem”

Source: Bloomberg

The Federal Reserve: Quantitative Tightening Ends

For almost two decades, the Federal Reserve has ballooned its balance sheet via quantitative easing, or QE, to fight a series of financial shocks. Beginning in 2022, it reversed course with quantitative tightening, or QT, which allowed bank reserves to fall, draining liquidity from the financial system, in an effort to tame the post-pandemic stimulus-fueled inflation. QT has now ended.

Tightening conditions in credit markets have triggered crises in the past. Currently, disruptions in the repo market, which provides liquidity and short-term funding for financial institutions, are raising concerns. Repo facility usage and spreads have spiked over the last couple of months. The Fed has the 2019 repo crisis on its mind, when disruptions forced it to intervene aggressively as reserves became scarce.

There is debate both inside and out of the Fed, as to how far reserves should be allowed to fall. Fed Governor Christopher Waller, who is on the short list to replace Jerome Powell as chairman next year, argues that reserves can safely fall to as low as 9% of GDP. With the recent announcement to end QT next month, the Fed seems to be cautiously stopping somewhere closer to 11%.

Running down reserves excessively risks a liquidity crisis, similar to 2019’s repo crisis. Scarcity in banks’ reserves limits lending to other institutions that need this cash to operate efficiently. It can also hamper primary dealers, who are instrumental in mopping up supply of treasuries as they are issued, risking disruption in the government bond market. Despite the end to QT, the Fed is still expecting to roll off its massive $2 trillion in holdings of mortgage-backed securities. The Federal Open Markets Committee also announced that it will reduce the duration of its balance sheet, absorbing less of the constant new issues of longer-dated supply, risking upward pressure on yields at the long end.

Funding markets have calmed down significantly since peak disruption, but problems remain. The Fed may be forced to once again use the balance sheet to relieve stresses. Powell already has said as much. Liquidity issues were exacerbated by the government shutdown and the pause in spending, as the Treasury accumulated a massive amount of money, effectively pulling liquidity out of the system. As the Treasury General Account spends its way back down, this may alleviate some pressures, especially in financial markets.

The flood of money that was pumped into the system that caused much of our inflation is unlikely to ever be unwound. The good news is that the end of QT, in addition to other new facilities the Fed has created, greatly reduces the risk of any funding market stress bleeding into the broader market or economy. Any increase in the balance sheet, along with the imminent spenddown of the TGA, will be a tailwind for financial markets.

Daily SOFR Spreads to EFF and RRP Rates

Source: Oxford Economics

Reserve Balances with Federal Reserve Banks Small Business Survey “Most Important Problem”

Source: Bloomberg

Source: Bloomberg

Source: Bloomberg

Key Market Indices Performance

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This commentary is as of Dec. 8, 2025, for informational purposes only and is not investment advice, a solicitation, an offer to buy or sell, or a recommendation of any security to any person. Managers’ opinions, beliefs and/or thoughts are as of the date given and are subject to change without notice. The information presented in this commentary was obtained from sources and data considered to be reliable, but its accuracy and completeness is not guaranteed. It should not be used as a primary basis for making investment decisions. Consider your own financial circumstances and goals carefully before investing. Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not indicators or guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification strategies do not ensure a profit and cannot protect against losses in a declining market. All indices are unmanaged, and investors cannot invest directly into an index. You should not assume that an investment in the securities or investment strategies identified was or will be profitable.

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