Japan Outlook: The First Step to Exit

Macroeconomic and Policy Dynamics

Japanese headline inflation has been moderating for 2023 so far, as global supply chains swing back to normal and energy prices rotates lower before the recent bounce. However, the pace of moderation has been hindered by stronger food prices (record chicken culling on bird flu in H1 2023 led to +36.9% egg price inflation) and see our 2023 inflation forecast revised higher to +2.8%. Our 2024 inflation forecast are also revised higher to +1.4% as we anticipate the substantial wage hike in 2023 to be filtered into the economy in 2024 (though we remain below consensus, as we feel that disinflation inertia remains). Unsurprisingly, BoJ’s Ueda has also highlighted the importance of wage growth in inflation dynamics and their dependency on which to decide their next step in monetary policy.

Strengthened by private consumption in Q1 and trade numbers in Q2, our forecast for 2023 GDP growth has been revised upwards to +2.0% but 2024 GDP growth has been revised downwards to 1.0% as private consumption remains under the shadow of inflation. Private consumption contracted in Q2 2023 and the outlook is not bright for the rest of 2023 and H1 2024 given real wage remains negative and household savings mostly depleted. Household spending has been contracting faster in Q2 2023 to -5% y/y in July despite wage growth begin to pick up its pace. The latest round of proposed wage hikes will lift some pressure of the household sector in 2024 but expect sluggish consumption in the rest of 2023 on still negative real wages. Government stimulus has faded out of the picture and we are not forecasting another round of stimulus with the current fiscal space. The Japanese government’s plan on introducing new policy on foreigner purchasing Japanese property may also negative affect residential investment.

Although domestic demand will be soft, it remains to be the primary driver for GDP in the coming quarters and should gradually be back on traction when wage growth filters into the system. GDP growth would be further supported by positive trade balance as long as JPY keep Japanese exports attractive.

Figure 1: Japan CPI, CPI ex Food & Energy and Labor Cash Earning (y/y)

Source: Datastream, Continuum Economics

The trade balance has surprised to the upside in Q2 2023 but it is not export driven, rather it is a slump in import that led to a strong trade balance number. And in fact, exports to China and Asia has fell throughout the first half of 2023 while export to U.S. and Europe grew. If Japanese trade has to grow sustainably, Chinese demand is inevitably an important factor. With the Chinese economy seeing little signs of rapid improvement, one could expect Japanese trade to not outperform in the coming quarter and first half of 2024. Japanese imports had risen significantly in 2022 on the slump in JPY & high energy price but with energy prices rotating lower and domestic demand weakens on inflationary pressure, Japanese imports has recorded double digit contraction in Q2 2023 but this is unlikely to be repeated . On balance, Japanese goods are attractive given the extremely soft JPY and should see Japanese trade balance to be positive in a medium run, but net exports will not provide the GDP boost in real terms as import will likely not slump further. 

Although headline CPI has been moderating since the beginning of 2023, the pace has been hindered by higher food prices. Fresh food prices remain the biggest inflationary factor, closely followed by other household items, such as clothes and furniture. Yet, we believe food prices have limited room to further increase as supply chain restraints have eased, the one off event of culling 16 million birds is unlikely to be repeated and global tightening feeds into the global economy (evidence from the falling PPI). Headline y/y CPI came in at +3.3% in August 2023, ex food & energy at +4.3% while ex fresh food came in at +3.1%. And from here on, we forecast CPI to tread lower with both food and energy prices rotating lower until Feb 2024 when we expect energy prices to rebound. The stubborn inflation has persuaded Ueda to think of policy changes and adjusted YCC in July 2023 to unofficially raise the upper target band of 10yr JGB yields to +1%. Ueda’s comment in Q3 2023 also suggest the bank would reassess current monetary policy by year end 2023 after reviewing wage and inflation data.

Japanese policymakers are beginning to shift their rhetoric to “trend inflation” (comments suggest this meansfrom 6 months to 2 years) possibly achieving the 2% target, which means that the BoJ is acknowledging current inflation is driven by wage and economic growth. BoJ has revised their inflation forecast in July 2023 and see headline y/y CPI for 2023 to be around +3%, ex fresh food at +2.5% and ex fresh food & energy at 3.2%.For 2024, the BoJ see headline CPI to be +1.5-2%, ex fresh food at +1.9% and ex fresh food & energy at 1.7%. 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 but such pricing behavior seems to be changing somewhat in the face of high inflation. The revision of the BOJ’s inflation forecast would steer BoJ towards their next step in monetary policy in Q1 2024. It seems that Q1 2024 would be the perfect window for BoJ to adjust their monetary policy before major central banks are expected to swing towards easing later in 2024. The BoJ could either remove YCC entirely or move interest rate back to 0%, depending on wage and inflation dynamics by year end 2023. We tend to favor the latter, as abandoning YCC would be disruptive.

Policy Outlook

The BOJ surprised market participants again in the July 2023 meeting by unofficially raising 10yr JGB yield cap from +0.5% to +1%, citing the need for more flexibility in the JGB market. Under the new adjustment, BoJ would allow 10yr JGB yield to reach +1% without any sharp spike. The BoJ has intervened when 10yr JGB yields reached +0.65% and +0.72% in a short period of time, firstly from the announcement on YCC changes on July 28 and secondly from Ueda’s comment in monetary policy direction on September 11. We forecast BoJ will likely allow 10yr JGBs yields to reach 1% by year end but any spike would meet with intervention to temporarily stop the rise in JGB yields. In Ueda’s latest public comment, he mentioned BoJ would now focus on “quiet exit” on current loose monetary policy when the data supports. Thus, we forecast Ueda would make further changes to the forward guidance on ultra-easy monetary policy. The 1^st option is for BoJ to remove YCC entirely in Q1 2024 and 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 if wage growth continues its current trajectory. We favor the latter alternative, as abandoning YCC could cause a yield shock and 10yr yields rising to 1.5-2.0% and hurt Japan’s economy.