Don’t look down
12 June 2018
Japan has had a sobering 2018 so far, with both growth and inflation coming in below expectations. Is this likely to trigger a policy response, or should we expect more of the same? In terms of economic activity, the disappointment of a contraction in Q1 is threatening to turn into a (technical) recession, with our Nowcast framework pointing to another negative quarter in Q2. This is significantly below our judgemental forecast (see Chart 8). This reflects our views that production and sentiment data have been distorted by idiosyncratic factors in the semiconductor sector, rather than a broader downturn in the industrial cycle, and that consumer weakness is adverse weather related. If the downside risks do materialise, this will raise significant questions about the policy outlook. Most notably, pressure will increase on the government to recalibrate its fiscal policy. At present, the government has pencilled in a VAT hike in October 2019. However, even with the additional revenue from this levy, it has been forced into a five-year delay of its target for a primary budget surplus. A final decision on the VAT hike will be taken after the release of the Q3 GDP data – set for November 14th. If momentum does not recover sufficiently, an implementation delay may be on the cards, putting fiscal consolidation plans into turmoil – and potentially testing market lethargy on debt sustainability.
Turning to inflation, the disappointments in H1 have been no less distressing. Inflation has stalled again, with the April core CPI decelerating to 0.7% quarter-on-quarter (q/q), from 0.9% in March. More importantly, the Bank of Japan’s (BoJ) preferred core core measure was a miserly 0.4%q/q in April (see Chart 9). This dashes optimism on the inflation outlook, with the BoJ rumoured to be considering revising down its price outlook – prompting media speculation that it will launch a review at its June and July meetings of why inflation remains so weak. On our key measures of inflation fundamentals, we have observed some positive signs such as a closing of the output gap in 2018 and a sustained rise in core CPI – although this has largely been driven by energy prices. The big disappointment has come in wage setting behaviour, with the labour unions’ fourth estimate of the shunto outcome indicating a 0.53% rise. This is a long way from the 2-3% consistent with the BoJ’s target and only a marginal increase from the 0.48% year-on-year in 2017, versus the BoJ’s hopes for a step change. Further, survey-based measures of inflation expectations have weakened of late. The key question is whether the BoJ will respond. Its new leadership team has retreated from comments guiding markets toward exit of late. We think the BoJ has been late to recognise the trap it finds itself in. We believe this has two elements. Firstly, essential to any successful policy exit will be improving inflation fundamentals. However, the current Yield Curve Control framework does not provide the firepower to generate sufficient momentum for fundamentals to endure an exit. Secondly, debt sustainability rests increasingly on financial repression, with the government inaugurating a debt-to-GDP target to accompany its primary deficit target. This requires nominal interest rates to remain below nominal GDP for a very long time – meaning a normalisation of debt pricing remains impossible until the government has achieved a primary surplus. The stakes around the price and growth outlook are clearly rising. However, we think policy settings are sufficient for things to get back on track in H2. However, events so far this year have demonstrated Japan’s vulnerability to a downturn.