Japan economic outlook, April 2024
Japan's economy is expected to grow in the second half of 2024, driven by wage growth, consumer spending, and a weak yen.
Japan’s economy navigated a challenging landscape in 2023: After real gross domestic product fell by an annualized 3.2% in the third quarter,1 the country narrowly avoided recession when real GDP grew by a mere 0.4% in the last quarter of the year. Household and government consumption have been notably weak, while business investment rebounded at the end of 2023. Meanwhile, a very weak exchange rate has kept exports growing strongly. The modest economic recovery, combined with a strong depreciation of the yen, caused Japan to slide from being the third to the fourth largest economy in the world in US dollar terms, trailing the United States, China, and now Germany.2
A stronger economic recovery and an appreciation in the value of the yen against the dollar this year could allow Japan to regain its standing as the third largest economy by 2025. Indeed, the Bank of Japan (BOJ) tightened monetary policy in March,3 which should support the value of the yen. However, the yen has since weakened further as uncertainty around the future path of monetary policy—both in Japan and around the world—persists.
The end of a negative era
The BOJ ended its negative interest rate policy at its March meeting, raising rates from –0.1% to a value between 0% and 0.1%.4 The central bank policy rate had been in negative territory since the beginning of 2016, and the rate increase was the first one in 17 years.
Not only did the BOJ raise rates, but it also abandoned its yield curve control, where it had targeted a specific rate for 10-year Japanese government bonds and stopped purchasing exchange-traded funds and Japanese real estate investment trust funds. The central bank also plans to phase out purchases of commercial paper and corporate bonds over the next year.5 The BOJ has not provided much guidance on how it plans to proceed with its purchasing of Japanese government bonds. However, we expect the central bank to taper its purchases gradually to prevent an overly flat or even inverted yield curve—the latter typically makes banks less profitable, which can erode capital available for loans and restrain economic growth.
Despite the relatively hawkish move from the central bank, officials have stressed that monetary policy will remain accommodative, suggesting that subsequent rate hikes may be limited. Part of their reasoning likely has to do with the fact that inflation remains relatively muted even if it is still running above the central bank’s 2% target.6 Headline inflation accelerated to a 2.8% year-ago rate in February, up from 2.2% in January.7 However, most of the acceleration was due to base effects from energy subsidies implemented in early 2023. After excluding fresh food and energy, prices were up 2.5% from a year earlier, down from a cycle high of 2.8%.8 The BOJ’s measures of underlying inflation all looked a bit better (figure 1). Trimmed mean inflation, which strips out any extreme variations to give a better sense of underlying inflation trends, was 2.3% in February, while modal inflation was 2.0%, and weighted median inflation was just 1.4%.9
Although inflation remains relatively muted, the BOJ is still likely to raise rates further—however only modestly. Wage growth is expected to accelerate this year, which should provide stronger support for inflation. Announcements from this year’s shunto—or wage negotiations—have been notably strong. For example, according to the announcement in March from the country’s largest labor union, Rengo, Japanese firms have agreed to raise pay by 5.25% this year.10 Base pay, which is likely a bigger driver of inflation, will grow by 3.64%—up from last year’s 2.25% growth.11 Announced pay raises from the shunto are typically higher than overall wage growth, as they exclude many workers employed by smaller firms. Still, the wage negotiations of the country’s unions provide a benchmark for other employers, suggesting that overall wage growth is likely to pick up in the coming months.
This year’s strong shunto satisfies the three criteria that researchers from the Japanese Center for Economic Research laid out to assess whether a so-called “virtuous cycle” of wage growth and inflation would emerge.12 Specifically, they noted that base pay increases should be higher than last year, exceed the rate of inflation, and exceed the rate of nominal GDP growth. It appears that base-pay increases will do all three once the final data is available. Unfortunately, the sizable pay increase is unlikely to fully reverse the decline in real wages seen since 2019. Real scheduled earnings, which exclude overtime and bonus payments, were still 4.3% lower in December 2023 compared to December 2019.13
Despite the effect on inflation, this year’s wage announcements should create an inflation-adjusted increase to wages, which in turn will support consumer spending. Real domestic household spending fell, although modestly, during the last three quarters of 2023. The Bank of Japan’s real consumption activity index was 1.3% lower than a year earlier in January.14 A decline in spending on goods has been driving the contraction, while spending on services has been modestly positive. Lower inflation and higher wages should reverse the trend soon. Consumer confidence has also picked up notably. For two-or-more-person households, consumer confidence in February reached its second highest reading since May 2019, adding to the bullish outlook for household spending.15
The yen defies economic theory
Typically, rate increases lead to currency appreciation. Theoretically, a higher interest rate would attract more foreign capital to Japan, thereby lifting the value of the yen. However, after the rate rise in March, the yen defied economic theory and depreciated, testing the psychological bound of 152 yen to the US dollar (figure 2).
Part of the problem is likely related to investor expectations. The rate increase in Japan was widely anticipated ahead of the meeting16 and so it was likely already priced into the value of the yen once the meeting announcement came. Around the same time, US central bankers started signaling that they expect to make fewer rate cuts than previously expected in 202417 as the US economy and inflation both have been unexpectedly strong. Both factors have likely contributed to the yen’s weakness.
Recent remarks from Japanese policymakers show that they are clearly concerned about the low value of the currency.18 The BOJ could raise rates further to support the yen. After all, a weaker currency raises the cost of imports, which can exacerbate inflation. However, raising rates further also risks suppressing inflation too much and putting Japan back on a deflationary path.
BOJ Governor Kazuo Ueda has so far insisted that monetary policy will be calibrated for inflation and not the yen. And, in his remarks to the Japanese parliament, he noted that currency market intervention was up to the Ministry of Finance,19 which has historically been the case. In October 2022, the Ministry of Finance intervened after the yen had lost about 30% of its value compared to 2021. Notably, the value of the yen in the week following the March BOJ meeting was slightly weaker than it had been in October 2022, on average,20 suggesting another intervention may be on the horizon.
The silver lining of a weak yen is the strength it provides to Japan’s international trade position. In January, Japan’s goods balance returned to a surplus for the first time since 2021, though it has since moved back to a deficit in February.21 Goods exports were up 7.8% in February 2024 on a year-over-year basis.22 Export strength comes despite relatively tepid global economic growth. Exports to the European Union, where several countries were in a technical recession last year, were up 14.6% from a year earlier in February.23 Exports to China, which struggled with domestic demand, were up 13.8% in the year to date, relative to a year ago.24 Although export growth has occurred across several goods categories, transportation equipment has been the largest source of strength. Transportation equipment exports were up 20.1% from a year ago in February.25 Services exports have also been very strong. The number of foreign visitors to Japan in February was the highest since July 2019.26 Travel-related exports spiked at the end of 2023 and were 29.1% higher in January than they were four years earlier.27
Although the BOJ has tightened its monetary policy, which would ordinarily restrain economic growth, Japan’s economy is likely to strengthen, particularly in the second half of this year. Monetary policy will remain relatively loose even if the central bank raises rates further—after all, the rate remains very close to 0%. More importantly, wages are poised to grow faster than inflation, which should reverse the decline in real consumer spending. The yen will likely strengthen later this year if the US central bank fully adopts a dovish approach as expected, but it is unlikely to snap back to its pre-pandemic value any time soon. This should prevent international trade from turning into much of a headwind this year.