Rates on the Rise: Can Investors See Through Takaichi's Budget Trick?

By Kenta Sato - Economic analyst

Prime Minister Sanae Takaichi, whose approval ratings had been sliding, has pushed ahead with a cabinet reshuffle and a shake-up of Liberal Democratic Party (LDP) executive posts in a bid to buoy her administration. Yet the road ahead is far from clear. The ruling coalition's landslide in the House of Representatives election and a fragmented opposition have left the Diet in a state of "one strong party against many weak ones," but the markets remain unforgiving. On top of a consumption tax cut with no clearly identified funding source, compiling a next-year budget that keeps swelling under the banner of "expansionary fiscal policy" is expected to prove difficult, and the view that this will push long-term interest rates even higher runs deep. Beyond the "trick" lurking behind the budget requests, persistent inflation shows no sign of easing and could squeeze the Takaichi administration.

With the LDP-backed candidate winning the Okinawa gubernatorial election on September 13, the administration appears to have regained momentum - but is there any "enemy" capable of cornering it? At one point the cabinet's approval rating kept falling, and a warning light seemed to flash over Takaichi's re-election in next autumn's LDP presidential race. But with the reshuffle and personnel changes now carried out, the rating is likely to rebound.

Record budget requests for a fourth straight year

Still, the outlook remains murky. The biggest reason lies in the market's reaction to the revival of the Japanese economy on which the prime minister is focused. On August 31, the Ministry of Finance closed the window for ministries' budget requests for fiscal 2027. The general-account total came to 143.07 trillion yen, exceeding the fiscal 2026 request (122.45 trillion yen) by roughly 20 trillion yen and setting a record for the fourth consecutive year.

Budget requests are how central government ministries ask the Finance Ministry for the money their programs need. The Ministry of Health, Labour and Welfare posted a record 36.58 trillion yen; national debt-servicing costs, which cover interest payments and bond redemption, came to 36.64 trillion yen (up 5.36 trillion yen from the fiscal 2026 budget, also a record); and the Ministry of Defense entered a record 8.9 trillion yen. The assumed interest rate was raised from 3.0% to 3.8% a year, inflating interest payments.

Major media outlets attribute the spending pressure to the Takaichi cabinet's creation of a "Strong and Prosperous Japan" investment framework — earmarked for crisis management and investment in growth sectors — and its decision to scrap the ceiling on fiscal 2027 requests so that budgetary measures can be taken under a multi-year plan. At an August 25 news conference, Finance Minister Satsuki Katayama signaled she would scrutinize requests strictly, saying she wanted to "achieve both the building of a strong economy and fiscal sustainability in an integrated way, under responsible expansionary fiscal policy."

The Takaichi cabinet has set a goal of raising the potential growth rate and, alongside an expansion of private investment, has rolled out measures to promote more than 370 trillion yen in total investment across "17 strategic sectors." Requests for the ministries' investment frameworks reached 12.2 trillion yen, exceeding the 10 trillion yen the government had assumed in its estimates. To be sure, against the criticism that the requests are too large, some may argue there is no problem when viewed as a share of GDP.

The "trick" behind the budget requests

But we must not forget that, beyond this "143 trillion yen-plus," there are also "item requests" that carry no monetary figure. This round of requests has a "trick" to it. First, the "143 trillion yen-plus" is only about 2% above the 140.61 trillion yen you get by adding the fiscal 2025 supplementary budget to the fiscal 2026 initial budget. Tallying up that figure is meaningless in itself, because it suggests the headline number was deliberately kept within a range not much different from the "initial plus supplementary" total.

In other words, everything else may have been shunted into "item requests" whose amounts are invisible. It is true that, with the National Security Strategy due at year-end, some portions - such as those at the Defense Ministry - unavoidably have to be filed as item requests with no amount stated at the request stage.

But item requests are especially conspicuous at the Ministry of Economy, Trade and Industry (METI). They line up one after another: (1) priority support for mass-production investment, R&D, and social implementation in AI, semiconductors, and robotics; (2) securing economic security for advanced-technology fields and critical materials; (3) strengthening dual-use and other technological and production bases; (4) investment and debt guarantees for startups important to economic security; and (5) bolstering domestic development of innovative pharmaceuticals and improving the environment for bringing them to market - nearly 15 items in all. METI-related requests have been announced at 7.79 trillion yen, but with the item requests added on, there is no telling how far the total will swell.

Those familiar with the markets will already see what this means. The market is worried about where long-term interest rates are headed as the budget balloons under the Takaichi cabinet's "expansionary fiscal policy." By this writer's reckoning, the item-request portion alone is likely worth "30 trillion yen" - and at the very least must exceed 20 trillion yen. As a result, the "actual request total" would swell to somewhere around 173 trillion yen.

How far the Takaichi cabinet will maintain fiscal discipline, and how it will face intensifying spending pressure heading into the year-end budget compilation, is unclear at this point. An increase on the order of 10 trillion yen over the fiscal 2026 budget (to 152 trillion yen) might be manageable through higher tax revenue and sales of state-owned assets, but anything larger will surely bring problems to the surface. As noted, the bulk of the budget is social security costs and bond redemption, which cannot be cut sharply. On top of that, doubts linger over whether the cabinet can strictly scrutinize the item requests that are its own centerpiece.

Another problem is that no account has been taken of the local-tax compensation for the consumption tax cut the prime minister pledged in her February Lower House election platform. Will the markets really overlook such "tricks"? This time, the Cabinet Secretariat earmarked about 7.2 billion yen for the Cabinet Public Relations Office - more than ten times the fiscal 2026 budget - which, turned around, looks like a reflection of the administration's own sense of crisis.

A swelling budget and the risk of higher rates

A budget that keeps expanding carries the risk of pushing rates up. At its Monetary Policy Meeting on September 17–18, the Bank of Japan plans to raise the policy rate from 1.0% to 1.25% — its first additional hike in three months, since the June meeting. The yield on the newly issued 10-year JGB, the benchmark for long-term rates, only just topped the 3% mark on September 1, for the first time in about 30 years since September 1996.

With rates rising in tandem around the world, inflation - led by high oil prices - is shaking the global economy. The weak yen, which briefly touched the upper 163-yen range against the dollar in July, is also a concern. Coordinated U.S.-Japan intervention pushed it back stronger, but large swings in the exchange rate hit not only corporate activity but also people's daily lives. September brings the biggest wave of price hikes of 2026, with food alone accounting for roughly 5,000 items marked up. Unrelenting inflation and rising rates could drive the public away from Takaichi.

An approval rating propped up by a weak opposition

The Takaichi cabinet's approval rating had been on a downward trajectory since May, but recent media polls show it turning up again. Even now, ten months after the administration took office, some surveys put it above 60%. Yet this likely reflects nothing more than the "split" among opposition forces in the Lower House and the scarcity of moments when the cabinet has faced tough questioning in the Diet.

In fact, a JNN poll conducted in September found that a combined 57% "do not rate at all" or "cannot rate very highly" the Takaichi cabinet's measures against high prices. More than 55% also believe that "a consumption tax cut is ineffective as a measure against inflation." Rather than being credited for the substance or execution of its economic policy, the administration is merely benefiting from a divided opposition - a case of the "fisherman's profit" amid a landscape of one strong party and many weak ones.

In December, the next fiscal year's budget and the outline of tax reform will be decided. How, in the end, will the markets judge the "budget trick"?