- Lose fiscal policy, together with a weaker currency…
- …should give a slight boost to inflation and GDP growth
- The cautious stance of the central bank suggests that the BoJ will remain on hold in the foreseeable future
- Our GDP forecast remains 0.7% in 2017 and in 2018 (without additional easing)
- Our inflation forecast is 0.8% in 2017 and 1% in 2018
- 2017 and 2018 USD/JPY forecast: 115 and 110 respectively
- Downside risks to growth, related to Trump’s protectionist policies
Slow economic recovery, while inflation remains weak
The Japanese economy recovered faster than expected in Q3. Real Q3 GDP growth increased to 2.2%, higher than GDP growth in the first half of the year (average 1.4%). Stronger Q3 growth was mainly the result of a strong contribution of net exports, while consumption growth remained weak, partly as a result of extremely bad weather conditions. The unemployment rate has fallen to the lowest levels since the late 1990s. However labour participation rate has risen. This rate has recovered from 58.5% in 2013 to 60.4% in October 2016. This, together with weaker corporate profit growth in the past year partly explain the subdued wage growth. Meanwhile, headline inflation has been negative since April, but has shown some signs of bottoming out, as oil prices are slowly picking up. Meanwhile core inflation ex energy ex food which has been trending down for some time, also turned in October for the first time in six months.
Monetary policy, no new stimulus ahead
The BoJ has taken a more cautious approach on its monetary policy recently and in our view, the likelihood of further easing in the near term has become less likely. We expect the BoJ to maintain its quantitative and qualitative easing (80 trillion yen per year) with yield curve control for the time being. The recent adjustment to monetary policy has been functioning well. Since the US elections, the yen has become weaker than before the cap on yields was announced (please see box below). Moreover the BoJ has an “inflation-overshooting commitment,” which intends to change the inflation mind-set. Indeed the BoJ’s announcement to “continue expanding the monetary base until the year-on-year rate of increase in the observed CPI (all items less fresh food) exceeds the price stability target of 2 percent and stays above the target in a stable manner” is a strong determination to achieve the price stability and to raise inflation expectations. However, we think that the cautious price setting will continue for some time. We don’t expect inflation to reach the 2% target in the next couple of years.
Fiscal policy comes to the forefront (again)
The three arrows of Abenomics remain in place. However, we have seen some small shifts between the arrows this year in favour of fiscal policy to stimulate the economy and less on monetary policy and structural reforms. Indeed over the past year, Mr Abe has passed no significant legislation. More fiscal stimulus could be considered in the coming year. Recently, Japan has put in place two supplementary budgets (in 2015 it was 3.3 trillion yen and this year it is around 4.6 trillion yen) and a next one could be on the cards. This is not included in our base scenario though. We do not see room for additional fiscal stimulus, which would increase the debt, without meaningful structural reforms. However, if Prime Minister Abe would stay in power until 2021, as has been suggested, this could lead to more fiscal stimulus and structural reforms.
Looking forward, we think the Japanese economy will continue to grow slightly above the trend growth rate of 0.5% in the coming two years. However, given the limited structural measures and the gradual rise of wages, we do not see yet a fast pace of growth and inflation. Inflation is unlikely to reach the 2% target before end FY 2018, as has been announced by the BoJ. In the meantime, we expect a weaker yen to give more support to the economy. We think the underperformance of the Japanese yen against the US dollar will persist in 2017 as real interest rate differentials between the US and Japan rise in favour of the US dollar. An unwinding of speculative long yen positions is also expected to fuel further weakness in the yen. We expect USD/JPY 115 in 2017. However as the BoJ’s share of JGB market is expected to rise to almost 50% by the end of 2017, we do not rule out that financial markets will start to anticipate that the BoJ will scale back its monetary stimulus in late 2017/early 2018. Given our view that inflation in Japan is also projected to rise from -0.2% in 2016 to 0.8% in 2017, the BoJ is also likely to tolerate a higher target for 10 year yields to reflect firmer inflation expectations. As a result we expect the yen to receive some support towards 110 by the end of 2018.
Risks to the outlook
On balance we see more upside risks than downside risks to our scenario in the near term. The upside risks to our GDP growth outlook are:
-Fiscal stimulus has been important for growth in the second half of 2016. We do not expect much larger extra stimulus in 2017. If there should be more stimulus, this could give a boost to the economy. We expect monetary easing to continue throughout 2017 and 2018. This means that the BoJ will continue with monetary easing and the yield curve control (though the 0% target on 10 year yields could be adjusted over time).
-Although we are cautiously optimistic of global growth in 2017, overall we see some improvement compared to our previous forecasts, particularly for the US and China. These are Japan’s two major trading partners. This could lead to stronger external demand for Japan. Both the US and China’s importance to Japan’s exports amounts to a bit more than 18%.
The downside risks are related to the potential external shocks, including:
-Any signs that the President-elect Donald Trump will favour isolationist policies or that the Chinese economy could be showing signs of weakness could lead to rising uncertainty, a stronger yen, which will likely be a drag for Japan’s external position.