Bank of Japan Slashes Forecasts as Indicators Point to Weakening Growth

More Bearish Outlook

Describing the outlook as "highly uncertain", the Bank of Japan (BoJ) sharply reduced its growth forecast for the current year and shifted to an effective neutral stance in monetary policy. In its biannual review of the economy, published today, the BoJ cut back its growth forecast for FY 2008/09 to 1.5% from the 2.1% projection made in the last review conducted in October. The forecast for core inflation was also raised markedly from 1.1% in annual terms from 0.4%, reflecting increased pressure from elevated fuel costs.

However, the BoJ also dropped its explicit commitment to gradually adjusting interest rates in line with the economy's recovery, stating that it was now not "appropriate to determine the direction of future monetary policy". Instead, the BoJ highlighted growing downside risks to economic activity and pledged "flexibility" in the conduct of monetary policy, indicating that concerns over growth are prevailing over the interests of price stability.

Slackening Activity

That stance was reinforced by a slew of high-frequency data that point to a deceleration in the economy's momentum. Industrial output fell by 3.1% in March from the previous month, reversing from the 1.6% gain recorded in February. It marked the largest monthly fall in production in more than five years. Publishing the figures, the Ministry of Economy, Trade and Industry (METI) described the overall trend in industrial production growth as "flat". Industrial shipments declined by 3.9% as inventories rose by 0.2%. Moderating external demand as the U.S. downturn reverberates, appreciation in the yen, and rising input costs are undermining production activity.

If corporate profit margins are eroded, investment could slow. Figures released by the government today showed that the unemployment rate fell marginally to 3.8% in March from 3.9% the previous month. In FY 2007/08, the unemployment rate averaged 3.8%, down from 4.1% in the previous year. However, the strengthening in the labour market has failed to translate into a more definitive improvement in consumer spending, as wage growth has remained muted while indicators point to a weakening of the labour market. The ratio of job offers to job seekers declined to 0.95—meaning that 95 positions were available per 100 applicants—from a peak of 1.07 in June 2007. The slowdown in hiring is most marked among small and medium-sized enterprises (SMEs). Overall household spending fell by 1.6% in March from a year earlier in price-adjusted real terms; outstripping consensus market expectations for a more moderate annual decline of around 0.5%, while underscoring the continued wariness of consumers.

Outlook and Implications

As private consumption remains weak, marked deterioration in the net export position could rob the economy of momentum. Export growth slowed to a three-year low in March as regional demand—which had provided some offset to falling demand in the United States—showed signs of cooling. Growth in regional trade is still closely allied with final-stage demand in the United States, Europe and Japan itself, with dynamism generated by the vertical specialisation of the production chain. Some buoyancy continues to be provided by emerging markets in Central Asia and the Middle East and by the significant productivity gains made by Japan's large exports, which have boosted competitiveness. In turn, the effect of the current downturn in consumer demand is largely concentrated in semi-durable goods, with a high exposure to fluctuations in consumer demand. If there is a significant downturn in global demand, it may be having more impact on second- and third-tier exporters, such as South Korea and China, while the demand for high-quality Japanese brand names is relatively unaffected. However, the net export position will be compromised by surging imports, inflated by the high global price of oil and other raw materials, which prompted a 30.2% fall in the trade surplus in March. Cost-push inflationary costs may also result in rising prices, further inhibiting consumer spending.

Subsequently, the BoJ needs to carefully negotiate between the conflicting demands of building downside risks to growth and accelerating inflation. Global Insight maintains its view that the leading rate will remain on hold throughout 2008 at 0.5%—a stance reinforced by the tenor of today's report. Further increases to contain inflation are deterred by the potential negative impact on domestic demand growth and the value of the yen, while rising prices and the apparent stabilisation of financial markets following the global credit crunch restrict the case for cuts. However, the BoJ is expected to resume gradual increases in interest rates in 2009 on the expectation outlined in today's report that the U.S. downturn will prove shallow and contained. Core inflation is forecast at 1.0% for FY 2009/10. Global Insight expects that the next 0.25-percentage-point increase will take place in early 2009 as growth returns and prices begin to trend upwards on a consistent basis.

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