Japan Outlook: Trend Inflation To Remain Below 2%
Bottom Line:
- GDP growth for 2023 is staying at 1.3% despite a surprisingly strong Q1 on private consumption & investment as such would be further squeezed by sticky core inflation, negative real wage and soft global economic outlook with tightening financial condition in the rest of 2023. Government stimulus driven growth has shown further signs of moderation and trade balance surprised to the downside in Q1 2023. Yet, trade is expected to rebound when demand picks in by H2 2023 on better Chinese economic recovery and attractive JPY exchange rates. We revised 2024 GDP growth slightly higher to +1.2% as inflationary pressure should begin to ease and breathe some life into private consumption. 2023 CPI Inflation forecast is revised higher to +2.5% and 2024 is also revised higher to 0.7%.
- We are forecasting a change in forward guidance in Q3 2023, before increasing the upper target band on 10yr JGB yields to 0.75% in late 2023, an attempt to offset the adverse effects of QE with yield curve control (YCC) after a decade long of easing and as a tilt toward data dependent policy making. We do not see the BOJ abandoning QE with YCC, as this would cause too much of an interest rate shock to the Japanese economy. We forecast no other policy changes before H2 2024.
- Forecast changes: We have revised our 2024 growth forecast higher to +1.2% and 2023 CPI higher to +2.5% from +1.5% to reflect the changes in inflation dynamics.
Macroeconomic and Policy Dynamics
The easing of supply chain restraints, lower energy price and global tightened financial condition has led to Japanese headline inflation moderation. However, CPI ex Fresh Food & Energy has been unfazed by aforementioned factors and continuously rose in H1 2023. Even so, our forecast is staying at +1.3% GDP growth (elevated by unsustainable private consumption and investment), the outlook for private consumption is bleak as real wage remains deeply negative in 2023 and household savings further deplete after Q1’s release. Household spending has shown sign of weakness in Q2 2023, along with deeper negative real wage as wage growth continues to miss estimate. The latest overall wage hike does not seem to inspire the forecasted magnitude of wage inflation and will be putting more strain on household balance sheets. But the other side of the coin will be slightly lower inflation in 2024 for the translation from wage inflation slips. The impact of government stimulus is fading out and would not provide much buffer to the Japanese economy. Looking forward, domestic demand remain the primary driver for GDP in the coming quarters and should be supported by the improving trade numbers.
Trade balance has surprised to the downside in Q1 2023 as global demand, especially Chinese demand, remains soft. The improvement in Q2 2023 remains choppy and the major drag lies in Asia exports. Exports to the U.S. and EU has been showing double digit growth on a year to year basis. Export to China in Q1 and Q2 has missed estimates but is expected to pick up some pace in the remaining 2023 and contribute as another potential driver to support economics growth. Japanese imports had risen significantly in 2022 on the slump in JPY & high energy price which had moderated and showing a drop in imports three months consecutively. Global demand for Japanese items should strengthen in the coming quarters on the soft JPY. Furthermore, another large trade partner of Japan – China has exited the “Zero-Covid” policy and Chinese economic activities should feedthrough in H2 2023, helping demand for Japanese goods. It would likely to remain a rocky road for Japanese trade, given the 2023 global demand outlook, but we are forecasting positive momentum in the coming quarters.
Japanese policymakers are centering their rhetoric of inflation towards “achieving sustainable inflation” instead of focusing on any specific level when both the headline and core inflation had long shot past the 2% target. To achieve sustainable inflation in the eyes of BoJ would mean “trend inflation” (term starts from 6 months to 2 years) reaching 2% and is driven by wage increase and economics growth. Moreover, BoJ governor Ueda has stated that the BoJ would not revise the inflation target because it remains the best for Japan in a medium term. The BoJ has privately long viewed the 2% inflation target as a long shot because of the Japanese business culture does not favor passing cost to customers in fear of losing them and so low inflation expectations were quite embedded. Headline inflation peaked in Q1 2023 but has not been moderating as swift as forecast and combined with sticky core inflation, it seems that the time to tilt adjust policy again has come and shifting the 10yr JGB cap would be the most logical policy decision before taking policy rate back to positive territory.
The headline CPI in April rebounded to 3.5% from 3.2% in March while ex-fresh food & energy CPI surged to 4.1% from 3.8% in March but is expected to show signs of moderation the coming quarter. Fresh food prices remain the biggest inflationary factor, closely followed by other household items, such as clothes and furniture. Thus, the sticky core inflation may prompt Ueda to make changes to the YCC but not strong enough to normalize policy by hiking rates if he would like to stay true to his stance in data dependency. We are forecasting Ueda to change BoJ’s forward guidance as soon as September, before revising 10yr JGBs upper target band to 0.75% for the Yield Curve Control tool. We do not see a rate hike in 2023 because inflation will be returning to below 2% in 2023/24 and economic growth are limited to close to 1%, neither are supporting for further policy normalization.
The banking crisis in United States and Switzerland did not affect the banking system in Japan and has not led to tighter financial condition. There has been no demand for USD funding operation from BoJ which seems to suggest Japanese banks are in much healthier status. However, the potential election in the lower house and political uncertainty surrounding it may keep Ueda waiting on the sideline before making his steps. We do not expect the BOJ to make major policy decision changes because these events.
The outlook for 2023 is looking like a return to the “Japanese” pace of GDP growth while inflation remains elevated. Growth is unchanged at 1.3% as fiscal stimulus have been digested and private consumption would be further limited by negative real wages throughout the rest of 2023. Government spending is unlikely be the white knight in economic growth once again as the Japanese government will turn to long-term fiscal policy consolidation. The Kishida government does not have the fiscal space to follow through to materially boost low-income households and reduce income inequality, though some increased taxes could be seen on the rich in the coming months. 2023 CPI is revised higher to +2.5% though the unsustainable inflationary factors will phase out and supply chain issue dissipates in H2. As the long-term wage and inflation expectations are the strongest in three decades, we expect wage growth to accelerate throughout 2024 . Therefore, we raised our inflation forecast in 2024 to +0.7%.
Policy Outlook
The BOJ surprise increase in the 10yr JGB cap from 0.25% to 0.50% on December 20 creates huge uncertainty over policy for 2023 in Japan and whether the BOJ end ZIRP and/or further adjust the QE with Yield curve control.. The new governor Ueda is sounding support to BoJ’s ultra-loose monetary policy but suggesting potential changes according to incoming data, as flexibility exists with the 18 month policy review to make changes. We forecast Ueda would make changes to the forward guidance on Yield Curve Control in Q3 2023 and could potentially be later if political uncertainty persists and CPI moderation picking up pace. Abandoning the 10yr yield cap could cause a surge in 10yr JGB yields, so the main option would be a further adjustment to 0.75% from 0.50%. The 2nd alternative is that the BOJ increase the deposit rate from -0.1% to zero or +0.1% to end ZIRP as a one-off adjustment but is not supported by current trajectory of data.