Japan - Getting closer to BoJ normalisation and yen recovery

Technical recession revised away; modest economic growth expected for 2024

Full-year GDP growth in 2023 was relatively strong at 1.9% (up from 1.0% in 2022), mainly driven by net exports. Still, after a strong first half of the year, growth momentum clearly weakened in the second half of last year, with private consumption contracting in the last three quarters of 2023 and the contribution from net exports fading. That said, initial GDP data suggesting the Japanese economy entered a technical recession in 2H-23 have been revised away on 11 March. This followed much stronger capital expenditure by private firms in Q4-2023, leading to an upward revision of the investment contribution to GDP. As a result, quarterly growth turned mildly positive in Q4-23 (+0.4% qoq saar), instead of the initially reported -0.4% (although the upward revision was weaker than consensus expectations).

Recent monthly activity data are a bit on the weak side. PMIs are pointing to a slowing growth momentum, with weakness concentrated in manufacturing. The composite PMI dropped to a three-month low of 50.6 in February. Industrial production fell by 7.5% mom in January, partly as a result of disturbances from an earthquake and the shutdown of auto plants. Retail sales in January only recovered modestly from the sharp drop in December, while annual growth of overall household spending fell deeper into contraction territory in January despite a pick-up in wage growth. By contrast, the latest reading (Q4-23) of the quarterly Tankan business conditions index is at relatively high levels.

We expect quarterly GDP growth to remain modestly positive in the coming quarters, mainly driven by a recovery in private consumption, particularly from Q2-24 onwards. We expect annual growth to slow to 0.7% in 2024, picking up to 1.1% in 2025. Our growth forecasts for 2024 and 2025 are close to consensus. Our annual growth forecasts for 2024 and 2025 for Japan (0.7% and 1.1%) are weaker than those for the US (2024: 2.1%, 2025: 1.9%). Compared to the eurozone, our growth forecast for Japan is a bit higher for 2024 (0.7% versus 0.4% for the eurozone) and lower for 2025 (1.1% versus 1.6%).

Disinflation continues, core inflation expected to stay above BoJ target during 2024

Following decades of low inflation/deflation, Japan also experienced an inflation spike in 2022/23 (triggered by energy prices following the Ukraine war), although inflation has stayed clearly below the pace seen in the eurozone or the US. Core CPI inflation (all items less fresh food), the favourite inflation indicator of the Bank of Japan (BoJ), peaked at 4.2% yoy in January 2023, and has gradually fallen back since, coming in at the BoJ’s 2% target in January 2024. In their latest assessment (January 2024), the BoJ expects average core CPI inflation to remain above 2% (range of 2.2-2.5%) in fiscal year 2024.

In the short-turn, inflation is expected to pick up again (nationwide numbers for February 2024 to be published on 22 March), as the effects from government subsidies initiated one year earlier will fade. Tokyo figures published early March (seen as a leading indicator for the nationwide average) indeed showed a pick-up in February. Wage negotiation rounds (Shunto) scheduled for this spring are expected to lead to higher wage growth, pushing up services inflation. Wage negotiation results of some large companies do indeed already point into that direction, although it remains to be seen to what extent medium-sized and small companies will be able to follow this.

Bank of Japan close to starting normalising its monetary policy framework

Although the pressure to change course (as expressed for instance in currency pressures) is fading as we move closer to the first rate cuts of the Fed and the ECB, the BoJ has signalled repeatedly that is considering the normalisation of its monetary policy framework (including the removal of the negative policy rate) after years of unconventional policies. With core inflation expected to stay above the BoJ’s 2% threshold, the general expectation is that the BoJ will start with normalisation in the coming months, following tweaks to its yield-curve-control framework last year. In its communication, the BoJ has put much weight on the ‘virtuous cycle between wages and prices’, bringing inflation sustainably back to the target of 2%. That would make it plausible for the BoJ to wait for the outcomes of the spring wage negotiations and for more indications that consumption will start recovering in Q2-2023.

Also taking into account the recent GDP and activity data, the moderate growth outlook, and the fact that forecasted rate cuts by the Fed and the ECB will take much of the pressure off, we still expect only a very gradual hiking path. A gradual approach would likely also been welcomed by the Japanese government, given the very high public debt ratio of around 250% of GDP. It is also plausible that the BoJ will first resort to some forward guidance and tweaks to its asset purchase programs/yield-curve-control framework before kicking off immediately with a gradual rate hike path.

All in all, we expect the BoJ to hike the policy balance rate to 0.0% (from -0.1% currently) in Q2-2024 (in line with the current median estimate of other economists), followed by a 25 bp hike in late 2024 (somewhat above consensus at the moment, but consensus looks to be shifting). That said, we do not rule out the possibility that the BoJ will already start hiking the policy rate in its meeting of 19 March (markets currently price in a 64% probability of a March rate hike; consensus forecasts for the 19 March meeting are not available yet).

Recovery of the yen to continue, but patience is needed

In February the market tested if USD/JPY could clear the high set in November (at 151.95). It came relatively close, but the high was 150.89. After several attempts, the move lost momentum and USD/JPY and EUR/JPY have started to decline (the yen has recovered). The main driver behind the yen recovery has been speculation that the Bank of Japan may start hiking the policy rate in March. We have seen this as well at the end of last year and then the market was disappointed as the Bank of Japan did not start its hiking cycle. Even though it may start this month, the communication and/or the pace of rate hikes may disappoint.

Despite this we expect the yen recovery to continue. It is likely that the narrowing of the spreads between the US and Japan and the eurozone and Japan (even though most of it is already anticipated) lead to lower levels in USD/JPY and EUR/JPY. A diverging path in monetary policy (BoJ hiking and Fed/ECB cutting) is supportive for the yen. But it is important to keep in mind that most action will be from the front of the ECB and the Fed. Indeed, we expect only a very gradual hiking path by the BoJ, as mentioned above.