Factors behind deflation and policy responses required of the government and Bank of Japan(Aug 2012)

◆Economic outlook revised: In light of the first preliminary Apr-Jun 2012 GDP report (Cabinet Office), we have revised our economic growth forecasts. We now forecast real GDP growth of +2.2% y/y for FY12 (previous forecast: +2.4%) and +1.4% for FY13 (+1.3%).

◆Main scenario and risks for Japan’s economy: Despite the existence of downside risks, as our main scenario we believe that Japan’s economy will continue to expand gradually, supported by (1) reconstruction demand related to the Great East Japan Earthquake, (2) pickup of the US and Chinese economies, and (3) further monetary easing by BOJ. Risks facing Japan’s economy are (1) any deepening of the European sovereign debt crisis, (2) a surge in crude oil prices stemming from geopolitical risk, (3) further appreciation of the yen, and (4) the current account balance turning negative in the future.

◆Factors behind deflation and policy responses required of the government and BOJ: In this report, we examine factors behind persistent deflation in Japan and investigate policy responses required of the government and the Bank of Japan (BOJ). Contrasting with BOJ’s optimistic price outlook, we anticipate that deflationary tendencies will persist for the time being. Our analysis of core CPI indicates that narrowing of the GDP gap and stable trend of inflationary expectations are factors augmenting prices and that sluggish employee compensation and slower growth of corporate goods prices are factors placing downward pressure on prices. Policies will be needed to increase employee compensation through higher sales and an improvement in the current low labor productivity of the nonmanufacturing sector (stemming from a low capital-labor ratio). Specifically, the policy authorities will need to firmly pursue economic policies to restore the economy centering on four points: (1) there should be consistent policies based on a firm vision (national vision and philosophy) of the top leaders, (2) instead of focusing only on domestic demand and the demand side, economic policies should be implemented that are well balanced and that embrace foreign demand and the supply side, (3) government finances should be rebuilt by raising the consumption tax and reducing expenditures centering on social security costs, and (4) the government and BOJ should work together more closely. Regarding the last, based on an analysis using the Granger causality test, a weaker yen and higher stock prices ensuing from further monetary easing by BOJ would be effective in ending deflation.