Deflation and rigid wage setting suppress Japanese real pay gains
A Bank of Japan working paper shows that prolonged deflation and labor market frictions suppressed Japanese real wage growth over the past three decades. Downward nominal wage rigidity forced firms to freeze wages, widening the gap between productivity and pay.
The mechanism of frozen pay
Analyzing worker-level microdata from 1990 to 2024, the Bank of Japan study finds that nominal wage setting was rigid in both directions during Japan's deflationary period.
Upward wage rigidity became particularly pronounced after deflation took hold in the late 1990s, preventing productivity gains from translating into higher compensation.
Firms restrained wage increases out of fear that future wage cuts would be costly under downward nominal wage rigidity.
Using a general equilibrium model, the authors demonstrate that this rigidity, combined with low job mobility and an emphasis on job security, increased wage markdowns.
Recent higher inflation has begun to weaken these rigidities, restoring wage flexibility.
Unlocking mobility and growth
The study provides counterfactual simulations showing that a steady two percent inflation rate combined with higher labor mobility would have significantly narrowed Japan's wage-productivity gap over the past thirty years.
Higher trend inflation reduces the effective cost of nominal wage rigidity, allowing real wages to adjust smoothly.
This improves the signaling function of wages, encouraging workers to move toward more productive firms and boosting overall macroeconomic productivity.
Structural reform beyond inflation
The study effectively exposes how prolonged deflation crippled Japanese pay growth for decades.
Yet monetary easing alone cannot fix the problem without structural reforms that encourage worker mobility.
Unless Japan dismantles deep-seated labor rigidities, higher inflation will fail to deliver sustained real wage growth.