Japan: Recovery in recess

Despite evidence of a notable dip in Japanese GDP in the second quarter, the BoJ didn’t budge at Friday’s Policy Board meeting. There was no change to monetary policy, with the vast majority of Board members content to maintain the commitment to increase the monetary base and its JGB holdings at an annual pace of about ¥80trn. There remained only one dissenter, with external Board member Kiuchi repeating his lone call to start tapering for the sixth consecutive meeting. And the Board left largely unaltered its economic assessment from that published following the mid-July meeting, still judging that the ‘economy had continued to recover moderately’.

While it was no surprise to us that policy was left unchanged, an acknowledgement of recent weakness in economic activity had seemed in order. At best the recovery appears to have paused in Q215. Consumption looks to have fallen back to barely above the post-tax hike trough. Exports declined at the steepest pace since 2012. And after a better first quarter, business investment also probably dipped. So, industrial output reversed the increase seen in Q1. And when the first estimate is published on 17 August, we expect GDP to have contracted by as much as 0.8%Q/Q.

In his post-meeting press conference, Kuroda was unmoved and predictably gave a defence of the BoJ’s upbeat economic outlook. He blamed recent weakness of consumer spending on the weather and expected to see a rebound in household expenditure in July. He also suggested that recent weakness in IP and exports should prove transitory too. But it goes without saying that there are significant downside risks to the Policy Board’s economic outlook. Household spending has been stuck in a rut since the consumption tax hike, with a drop in consumer confidence in July to a six-month low hardly signalling a step change for the better. Moreover, uncertainties abound about external demand not least from China, whose imports from Japan fell more than 10%Y/Y in the first seven months of the year. And the BoJ’s GDP growth forecast for FY15 of 1.7%Y/Y, published less than a month ago, seems bound to be revised down in due course.

Nevertheless, on balance, we are cautiously optimistic that Japan’s economic recovery will regain traction over coming months. Business sentiment surveys remain consistent with a near-term return to economic expansion. With profit margins at an all-time high, firms appear to be stepping up domestic investments: if the Tankan is to be believed large manufacturers are planning to increase capex at the firmest rate since 1989. A surge in housing starts in June suggests that private sector construction will provide support to growth. And Kuroda’s comments that household income growth will be consistent with firmer consumption don’t seem farfetched: June’s near-2½%Y/Y decline in labour earnings, the most since 2009, reflected unusual timing in the payment of summer bonuses this year while regular wage growth was the firmest since 2008. So, we expect overall wage growth to bounce back in July, and real household disposable income should maintain an upwards trend as employment rises and inflation remains subdued.

Given the dip in GDP in Q2, however, our expectation for full fiscal-year growth is about half the pace forecast by the BoJ. And not least given renewed weakness in the oil price – currently almost one fifth below the level assumed in its projections – we expect the BoJ eventually to cut sharply its inflation forecast of 0.7% for this year to a tiny fraction of the increase of 1.7%Y/Y expected when it expanded QQE less than ten months ago. While Kuroda continues to insist that stronger economic growth, diminished spare capacity and higher inflation expectations will push inflation up to the 2% target next year, that figure is about twice as high as we dare to forecast. Indeed, given the past relationship between Japanese output and inflation, and the paltry evidence that inflation expectations have been boosted by QQE, we suspect that inflation will remain little higher than 1% over a medium-term horizon.

If, as we anticipate, inflation remains subdued well into 2016 and beyond, expectations of additional monetary stimulus will rise. But in the absence of new unforeseen shocks – such as a double-digit percentage renminbi depreciation – we think the BoJ will be reluctant to act. The marginal benefits of more rapid JGB purchases and an accompanying increase in the monetary base target might be questionable, while the Board might be wary of a potential negative impact on JGB market functioning. Given that it is already buying about 90% of gross JGB issuance, there are also doubts about the feasibility of achieving an increased volume of JGB purchases for a sustained period. While the BoJ might be tempted to increase its purchases of certain other assets – most notably ETFs to give a further boost to the equity market – such an incremental policy adjustment would likely have a modest macroeconomic impact and would seem out of character for Kuroda who appears to favour ‘Shock and Awe’ policy.

Given the limitations of the available policy options, and deflation having been the pre-QQE norm, the Policy Board could view a 1%-inflation outlook as a glass half-full rather than half-empty. And so, if, as we think, Japan’s economic recovery is merely in recess and there will be no return to recession, the BoJ’s next policy move might well be to taper its asset purchases. Not least given the next consumption tax hike due in April 2017, however, the time for that would still likely be several quarters away.

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