Growth above potential, still low inflation

Economic activity became more stable in 2016, as private consumption showed some signs of improvement after two years of contraction and exports gained momentum in the second half.

Supported by a temporary fiscal stimulus, improved global demand conditions, accommodative financial conditions and high corporate profit margins, economic growth is expected to accelerate to 1.3%  this year. Thus. it will remain above the potential growth rate (0.7%, Bank of Japan estimate).

The tight labor market - the unemployment rate has fallen to its lowest level since 1994 - should eventually exert upward pressure on wages and bring about higher inflation. To date, however, the wage trend remains soft and consumer price inflation has been hovering around the zero line in the early months of 2017. The momentum towards achieving the price stability goal of 2% is not yet firm. Thus, we do not expect the BoJ to forgo its accommodative monetary policy for the time being.

Improving the fiscal situation remains a core requirement for economic policy

Japan stands out for the high level of government debt. Gross debt amounted to 238% of GDP in 2015 and looks set to increase further in the near term, as the fiscal policy stance will remain expansionary amid the supplementary budgets approved over the past year. For the time being, the impact of high debt is mitigated by low-interest rates, helped by large-scale government bond purchases by the BoJ and a home bias of Japanese investors.

As a result, the share of government debt held by foreign investors is still relatively low. Besides limiting government spending and a steady increase in revenues, finding a solution to Japan’s government debt problem requires higher nominal output growth. Efforts by the Abe administration to increase the female labor force participation – to counter the aging population problem – have yielded positive results. Other reforms have yet to translate into stronger domestic growth.