- It has been nearly two years since the BoJ launched its unprecedented monetary easing programme, aimed at achieving a 2% inflation target in two years. However, a weak economy and lower oil prices make it unlikely this goal will be reached. We expect further monetary easing in July, with the risk that it could be earlier, and core inflation (ex food) to reach 1.0% in FY 2015.
- Over the coming quarters, we expect economic activity to gain some momentum. We maintain our FY2015 GDP growth forecast of 1.4%, picking up from -1.0% in FY 2014. We expect the yen to decline to 130 by the end of this year and 135 in 2016.
Inflation target off track
In his fight against deflation, Prime Minister’s Abe made a promising start in 2013. However, lately there has clearly been a delay in reaching the 2% inflation target. In January, the BoJ revised its FY 2015 core inflation forecast downward to 1% from 1.7%, mainly on account of lower oil prices. This was, seen as a signal that inflation was off track. Indeed core CPI ex-VAT has been trending down since August 2014 and fell to -0.2% in February 2015. We think the slowdown in inflation is the result not only of the lower oil prices, but also of the weaker economic activity and the longer than expected recovery from the VAT hike. It is therefore unlikely that the BoJ will reach its inflation target in the short run.
After contraction, a modest recovery this year
Indeed, economic activity has not been supportive for inflation. The Japanese economy slowed after the consumption tax hike in April 2014, mainly as a result of weaker consumption. A modest economic recovery is, however, on the cards. We see a more positive outlook for consumption, while net exports should contribute to growth in the coming time. If the economy improves, this would put upward pressure on prices, but the process will be gradual.
More positive outlook for consumption…
Although data on consumption continues to show weakness, we think that households are facing more favourable conditions. On the one hand, the shunto (spring wage negotiations) suggest stability and even stronger household income growth. Major manufacturers plan to lift base pay by around 0.3 ppts more than last year, reaching around 2.5% in 2015. While this is not exceptional wage growth, it does mean a boost for consumer sentiment. On top of this, lower oil prices will boost disposable income. Consumer confidence has already been trending up in the past months. In particular, real wage growth should pick up given the low inflation environment. On the other hand, the postponement of the consumption tax has also been received well by households.
… while external position to strengthen further
Japan’s trade balance has shown substantial improvement, mainly as a result of cheaper oil prices, which have reduced the value of imports. The impact of the yen’s depreciation on export growth has been somewhat limited. The change in the production structure of exports, which has resulted in the reallocation of Japanese manufacturing production overseas, is limiting the impact of a weaker currency. Still, real exports have recently started to rise. Meanwhile, the impact of a weaker yen on tourism from abroad, mainly from Asia, is gaining momentum since last year, up 30% compared to a year earlier. We expect the yen’s depreciation will support export growth in time and continue encouraging tourism, while lower oil prices will continue to reduce import prices.
But starting point for inflation low
The deflationary past in Japan significantly affects the behaviour of households and investors. It continues to influence wage determination and hiring practices. There is even pressure for the BoJ not to rush to meet the inflation target. However, this would come at the cost of the credibility of the central bank and of the progress made in wage negotiations. The BoJ has signalled that the deflationary culture is slowly changing. But they have mentioned that falling fuel prices will keep inflation subdued this year. We expect inflation ex VAT to remain in negative territory in the coming months, picking up towards the end of the year. In fact, inflation undershooting the target, points to additional monetary easing in combination with further implementation of the growth strategy in sectors such as the labour market.
Inflation undershoot points to further BOJ easing
The BoJ has so far announced two rounds of asset purchase programmes, in April 2013 and October 2014, and we expect another round of easing this July. The main benefit is seen in the currency, which has weakened considerably. The real effective exchange rate has depreciated by around 26% since the first QE programme. However, this effect works with a lag, and its impact on inflation and stronger growth have yet to materialise. There has been a strong shift to investments in higher risk assets. The Nikkei has rallied despite the weak economic activity. A stronger equity market complemented by reforms regarding corporate governance taken by Prime Minister Abe are intended to unlock the high levels of cash hoarded by firms. Recently a few companies have said that they would increase cash returns to shareholders, which is a positive signal.
Small steps towards fiscal consolidation…
Another challenge for Prime Minister Abe is fiscal consolidation. The VAT tax hike from 5% to 8% in April 2014 dealt a sharp blow to domestic demand, which pushed the economy further away from its growth potential. This has made authorities more cautious about plans for fiscal consolidation in the near term. As a result, in December 2014 the ruling party proposed modest fiscal reforms. These mainly focused on a reduction in the effective corporate tax rate to boost the economy, while at the same time expanding the tax base (but leaving small and medium-sized firms out of the equation) to offset the fiscal impact of the tax reduction.
…despite postponement of VAT tax hike
The consumption tax hike, which was planned for last October, has now been postponed to April 2017 with no economic conditions attached. Given the recent economic developments, this postponement seems reasonable. We think that stimulating the economy is a priority now. The fiscal position is not a threat to Japan in the short term, but fiscal consolidation needs to start as soon as 2016 given that the downside risks – including an ageing population and labour shortages.
Debt sustainability risks low in the short run…
In the absence of strong GDP growth and fiscal consolidation we don’t expect much improvement in the fiscal accounts. In the short term, however, we see that the government can easily finance itself. Indeed, government financing is not an issue with low interest rate rates and long maturities, with an average maturity of 8.5 years and a stable investor base and the BoJ purchasing a large part of the issuance. But the question is whether the high domestic debt remains sustainable in the long run.
…but bigger in the long run
There are, of course, risks in relying largely on domestic financial institutions for the investor base. And medical and pension costs are increasing given the quickly ageing population. On top of this, the household saving rate has recently turned negative. This could pose a problem for government debt financing in time, unless it is offset by higher corporate savings. We therefore think that, going forward, Japan will need a combination of solid economic growth and fiscal consolidation to improve its public finances. In June, the government will present a new fiscal plan to achieve the FY 2020 target, which should signal the strategy of government and its intentions for fiscal consolidation.