Japan: contraction in GDP suggests tax hike will not be cakewalk after all–more BoJ easing back in focus

In Japan, Q2 GDP contracted sharply by 6.8% q/q ann. (consensus: 7.0% q/q ann.) having expanding 6.1% q/q ann. in Q1.

While headline GDP growth was broadly in line with expectations, the details were relatively weak. Private consumption contracted a whopping 5.2% q/q (consensus: - 3.7% q/q) having increased 2.2% q/q in the previous quarter. Part of the sharp contraction in private consumption in Q2 can be explained by frontloaded consumer purchases ahead of the consumption tax hike in April; hence, to some degree, this should prove temporary.

Nonetheless, today’s GDP data also suggests that the negative impact from the consumption tax has been as least as large as in 1997, when this tax was last raised from 3% to 5% (in April 2014 it was raised from 5% to 8%). In 1997, private consumption in Q2 in the wake of the April tax hike contracted 3.5% q/q having expanded 2.2% q/q in the previous quarter.

Net exports contributed 1.1 percentage points to the 1.7% q/q growth in GDP in Q2 14. However, this was solely due to a 5.6% q/q drop in imports. Exports in Q2 declined 0.4% q/q and one of the major concerns for the Japanese economy remains that exports continue to disappoint despite the substantial depreciation of JPY since late 2012. Housing investments declined 10.3% q/q in Q2 while non-residential private investments (mainly corporate investments) declined 2.5% q/q; however, this was after increasing a solid 7.7% q/q in the previous quarter. Inventories added about 1.0 percentage points to q/q GDP growth, which was more than expected and also a little bit of a concern.

We do expect GDP to return to positive growth in Q3, but the strength of the recovery is looking fragile. Ahead of today’s data, it was gradually becoming the consensus that the Japanese economy would be able to weather the consumption tax relatively unharmed. This has also been the view of the Bank of Japan (BoJ), which has even refused to regard the hike in the consumption tax as one of the major risks to its outlook (a bit outdated, the BoJ sees the major risks as mainly external: US recovery, European debt crisis and a slowdown in emerging markets). The BoJ’s main argument has been that employment growth and eventually higher wage growth will be able to compensate for the negative impact from the consumption tax hike.

The sharp contraction in GDP in Q2 will, in our view, not immediately be enough to force the BoJ into additional easing. For BoJ, it will be decisive to what degree the Japanese economy recovers in Q3 and it will need data for another couple of months before it can make a final judgment. Currently, the economic indicators are giving mixed signals for Q3 but they increasingly suggest a relatively subdued recovery in Q3 (see charts below).

In our view, GDP growth will rebound to above 3% q/q ann. in Q3 before again slowing to below 1.5% q/q ann. in the following quarters. If we are right, the implication is that GDP growth in 2014 will be about 1.0% (consensus: 1.4%) and less than 0.7% in 2015 (consensus: 1.2%). This forecast is based on the assumption that the government will also raise the consumption tax from 8% to 10% in October next year and will not announce additional fiscal stimulus. The government has announced that a final decision on the consumption tax hike next year will be made at some stage in Q4 and will depend on the development of the Japanese economy in Q3. If Japan does not raise the consumption tax next year, it will put Japan’s debt sustainability into question (the goal is to balance the primary budget deficit by 2020). The BoJ will have an incentive to respond relatively quickly with additional easing if it wants to influence this political decision in Q4.

We expect the BoJ to soften its statement further in the coming months. At its August meeting, it acknowledged that exports (and industrial production) have been weaker than expected. The next logical step will, in our view, be to accept that there is downside risk from the recent consumption tax hike. At its 31 October meeting, the BoJ will publish a new macroeconomic forecast and will probably be forced to make a major downward revision of its GDP forecast in that connection. Hence, this will, in our view, be the first and also best opportunity for an early easing move. Although inflation is expected to decline slightly in the coming months, it is less likely that the BoJ will change its inflation forecast markedly in October. The inflation forecast is more likely to be revised lower in early 2015 and this could be an argument for postponing additional easing until 2015.

If the BoJ does ease, it will most likely be by increasing the target for the annual expansion of the monetary base (the main policy instrument) by JPY15-20trn from JPY60-70trn. The monetary base is mainly increased by purchases of government bonds, but the BoJ will probably also expand its programme for stock purchases through exchange traded funds.

For JPY, the short-term macroeconomic outlook for Japan has become more negative for JPY. That said, it should be remembered that Japan is already easing extremely aggressively and most likely will continue to do so well into 2016. In the medium term, this is the anchor for our call of a weaker JPY and it is not dependent on additional easing measures from the BoJ.