Japan’s technical recession and the BOJ’s woes

February 21, 2024

Japan is in the throes of a technical recession as its economy contracted again in the October-December period, with official GDP numbers falling to $4.2 trillion as against $4.5 trillion for Germany in 2023. This also meant that the country lost its title of the world’s third-largest economy. Official figures suggested that the Japanese economy shrank by 0.4 percent in the December quarter compared to 2.9 percent in the previous one, the root cause being the high inflation that crimped domestic demand and private consumption. Inflation Rate in Japan decreased to 2.6 percent in December from 2.8 percent in November of 2023.

Image via Financial Times1

These numbers could complicate the strategy unveiled by the Bank of Japan (BOJ) to bring down inflation to its 2 percent target. The central bank, which had retained its ultra-loose monetary policy at its first meeting of 2024 (held mid-January), had forecast core inflation to be around 1.9 percent, thus confirming that the economy was moving in line with their projections around inflation. In fact, Governor Kazuo Ueda was confident enough about reining in inflation that the BOJ kept interest rates at -0.1% while sticking to its yield curve control policy that keeps the 10-year government bond yield at 1 percent upper limit.

How did the BOJ see things going forward?

In its quarterly economic outlook, the BOJ had lowered the median growth forecast for core consumer prices to 2.4 percent for fiscal 2024 starting April as against 2.8 percent estimated in October – the reason being a softening of oil prices. In the note, the central also marginally hiked the core CPI inflation estimate for fiscal 2025 to 1.8 percent from the 1.7 percent forecast earlier while sticking to its median forecasts for fiscal 2024 at 1.9 percent.  “Underlying CPI inflation is expected to increase gradually toward achieving the price stability target, as the output gap turns positive and as medium- and long-term inflation expectations and wage growth rise … although there remain high uncertainties over future developments.” the BOJ said in the note2.

On the wages front, the central bank was hoping that annual spring wage negotiations would result in some meaningful increases. The challenge for the BOJ here is that real wage increases alone would encourage consumers to spend more, leading to sustainable and stable inflation, driven largely by domestic demand. However, unlike the US economy where wages have grown alongside inflation, Japan’s real wages sank 2.6 percent in the December quarter, its sixth consecutive quarter of decline. The BOJ was expecting the softening of energy and food prices to ease inflation that was propped up by a weaker Yen causing exports to become more expensive. In tandem, a surge in domestic demand fuelled by wage growth was seen as a means to stabilize inflation around manageable levels, which would help BOJ to normalize its rates during the next Board meeting scheduled in April.

The pros and cons of a rate hike

Market experts believe that exceeding the target necessitates action to stabilize prices and prevent long-term inflation expectations from anchoring higher. There is also added global pressure on the BOJ as other central banks have been raising rates, which potentially results in excessive yen depreciation. They believe that a rate hike could also signal confidence in the economy and encourage businesses to raise wages to address the real-wage decline. However, there is also a section of economists who feel that raising the rates could hinder the recovery of Japan’s economy and dampen business investments, especially in the wake of the recent shrinkage of GDP. They also question whether a rate hike could add to the prevailing high debt levels of Japanese companies and households.

Where does the GDP shrinkage leave BOJ?

However, the latest official data around a shrinking economy could derail some of the BOJ’s plans as it could complicate the rate normalization program of Kazuo Ueda with some fiscal support from Japan’s premier Fumio Kishida. The Japanese economy contracted 0.1 percent in the fourth quarter compared to the previous quarter, having shrunk by a revised 0.8 percent in the third quarter from the previous one. This has led to economists considering the onset of a technical recession. However, some believe that while jobs have reduced, the unemployment rate itself dipped to an 11-month low of 2.4 percent in December with the BOJ’s own Tankan Survey claiming that business conditions across industries remained the strongest since they’ve been from the fourth quarter of 2018.

With the household savings rate turning negative, the challenge now is to find ways to prop up domestic demand with the hope that inflation numbers will come down as anticipated by the BOJ. And here lies the challenge. While the rate of price rise has slowed gradually, the rate for the inflation basket minus food and energy has exceeded BOJ’s 2 percent target for 15 straight months now – continuing with its negative-rate regime all through this period. Now, the weaker GDP print could raise serious questions over the central bank’s preference for inflation in the country to be driven by domestic demand. Its expectation of strong wage increments in Spring could prove to be the litmus test. Last October, Japan’s umbrella labor union Rengo reiterated that it would demand a 5 percent wage hike in the spring wage negotiations, having secured its biggest raise in three decades in March 2023.

For the BOJ to move away from its negative rates regime in April, wage negotiations could become crucial. Of course, the shrinking GDP numbers that the official data threw up mid-February do prove that high inflation has definitely hurt domestic consumption in spite of the prospects of higher wages down the corner. For now, the BOJ is hoping that better corporate profits could translate to higher wages. And in case, this doesn’t materialize, would the central bank have to continue to maintain a loose monetary policy after April? Well, only time will tell.

1. https://www.ft.com/content/088d3368-bb8b-4ff3-9df7-a7680d4d81b2
2. https://www.boj.or.jp/en/mopo/outlook/gor2401a.pdf