Two steps forward, one step back
12 December 2017
With the economy motoring along and inflation steadily rising, 2017 has been a good vintage for Japan. The obvious question is whether this can provide a springboard for a more spectacular 2018. While the momentum is clearly positive, fundamentals are signalling a rather different outlook with an underwhelming environment both for growth and prices in the 12 months ahead. The first thing to point out is that much of the recent good news on growth has been aided and abetted by a much improved external environment, which has contributed positively to growth in six of the last seven quarters – representing a return to the pre-crisis environment. However, positive net exports also hint at a more troubling story at home. Policy settings are aimed squarely at boosting domestic demand, with lower real rates to trigger a rise in investment and spending allowing the country to unwind its chronic and persistent financial imbalances. In such a scenario, we would expect net exports to be less robust as rampant domestic activity sucks in imports. In reality, we expect overseas demands to continue to lead the way in 2018.
So what of domestic demand? We should state that prospects here are better in 2018 than they have been for a decade, but our base case is for Japan to continue to frustrate. The main barrier appears to relate to the falling spending power of Japan’s households. The labour share of income has been falling since the mid-1990s, but this trend has accelerated under Abenomics as corporate profitability has risen much faster than incomes. Admittedly, while the outlook for wage hikes is much better in 2018, we still expect the labour share to continue to lag, driven by a host of structural factors including changes in technology, migration, participation rates and productivity. The omens for corporate profitability to feed through to capex appear more encouraging. Sentiment measures are riding high, while industrial production and a machinery order backlog point to solid capex ahead. This was certainly reflected in the Development Bank of Japan’s recent survey of planned capex (see Chart 8). However, corporates response in the key Tankan Survey have been disappointingly downbeat on capex plans in FY2017, with all eyes on whether this persists when the latest survey is published this week. We suspect that companies will continue to take a cautious stance, preferring to focus on margin improvement strategies until their downbeat growth expectations improve (see Chart 9).
Regardless of the challenges ahead, we do think 2018 will be another year of above-trend growth for Japan. So what hope that this translates in to a better outcome on prices? We think the Bank of Japan’s inflation target is even more ambitious than just the stated 2%, with structural forces pushing down prices for rents and public services. To hit its target the Bank needs a significant overshoot in those items that are more sensitive to domestic economic trends. This is unlikely in the next 12 months and the task may become even more complicated if the distortions from government policies such as free education and the VAT hike start disrupting the progress of the CPI basket still further. In this environment, we expect the Bank to batten down the hatches, keep its yield curve control framework unchanged and hope that a more disruptive shock to the cycle does not materialise. This should allow PM Abe to focus on the politics of a generational opportunity to amend the constitution.