Japan to No Longer Meet the Domar Condition in 2030 Amid Rising Long-Term Interest Rates
― Policy Management Premised on Monetary Policy Normalization ―

In Japan, long-term interest rates have been rising, and the government’s interest payments have also been increasing. The Domar condition, under which the long-term interest rate, or effective interest rate, remains below the nominal economic growth rate, is an important premise for stabilizing the government debt-to-GDP ratio. In Japan, this condition held throughout the 2010s, but the environment is changing significantly.

An analysis covering OECD countries confirms that the Domar condition tends to be less likely to hold in countries with large government debt and low potential growth rates. It also tends to be less likely to hold in countries with high inflation volatility and low central bank holdings of government bonds. These results suggest that, in a phase in which supply constraints intensify and monetary policy normalization proceeds, maintaining the Domar condition will become more difficult than in the past.

According to future simulations, in Japan the Domar condition will cease to hold on a persistent basis around 2030, and by 2040 the effective interest rate will exceed the growth rate by 2 percentage points. In this case, the long-term interest rate is calculated to rise to the low 4 percent range. This result largely reflects the effects of monetary policy normalization. In addition, the failure of the Domar condition to hold can push up government debt and, through an increase in the fiscal risk premium, can create a selfreinforcing vicious cycle that makes the condition even less likely to hold. The United States, the United Kingdom, Germany, and other countries are also expected to face phases in which the Domar condition does not hold, but Japan, which has government debt that is exceptionally high even among major countries, is more susceptible to such a process.

In an environment in which the Domar condition does not hold, the government is likely to have an incentive to make the central bank postpone monetary policy normalization and thereby restrain interest payments. However, this could impair market confidence and instead reduce fiscal sustainability. It is desirable for the government to shift to fiscal management premised on monetary policy normalization and to position the Domar condition as an axis for evaluating policy management.

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