IMF Urges Japan to Continue Interest Rate Hikes and Avoid Consumption Tax Cuts

The International Monetary Fund (IMF) has urged Japan to continue raising interest rates and avoid further fiscal stimulus, warning that cutting the consumption tax could weaken the country’s ability to withstand future economic shocks. The recommendation comes as newly elected Prime Minister Sanae Takaichi’s decisive victory has intensified market focus on Japan’s monetary and fiscal policy direction.

Takaichi, widely seen as dovish, has pledged to suspend the 8% consumption tax on food for two years. However, the IMF cautioned that reducing the consumption tax would erode Japan’s fiscal space and increase fiscal risks at a time when the country faces mounting debt pressures. According to the IMF, near-term fiscal policy should refrain from further loosening and instead adopt a credible medium-term fiscal framework with a clearly defined fiscal anchor.

The IMF also emphasized the importance of the Bank of Japan’s independence, stating that its continued credibility is crucial to anchoring inflation expectations. With inflation exceeding the BOJ’s 2% target for nearly four years, the central bank has already exited its massive stimulus program in 2024 and raised its policy rate to 0.75%, a 30-year high, following multiple hikes including one in December.

The IMF said gradual interest rate hikes should continue, guiding the policy rate toward a neutral level by 2027 if economic projections remain on track. However, higher borrowing costs could complicate Takaichi’s tax cut and spending plans, which previously triggered volatility in Japan’s bond market and the yen.

Japan’s high and persistent public debt remains a key concern. Roughly a quarter of government spending is financed by debt, with about half held by the BOJ. As bond purchases are tapered and the central bank reduces its balance sheet, the IMF advised close monitoring of market liquidity. If volatility threatens stability, the BOJ should be ready to conduct targeted emergency bond-buying operations.

The IMF also welcomed Japan’s commitment to a flexible exchange rate regime, noting that yen flexibility helps absorb external shocks and supports price stability.