OECD Economic Outlook, Volume 2022 Issue 2

Japan

Real GDP growth is projected at 1.8% in 2023 and 0.9% in 2024. The new economic policy package will support domestic demand, partly offsetting subdued household confidence and real income. Loss of momentum in trading partner economies will moderate exports. After peaking in the course of 2022, headline consumer price inflation will fall back in late 2023 as energy prices stabilise, but then gradually increase again towards 2% in 2024 as wage growth gains momentum. The labour market will continue to tighten gradually, with the unemployment rate falling to 2.4% in 2024.

The measures to protect the most vulnerable households and firms in the face of higher prices should be temporary and more targeted. Monetary policy will remain accommodative but yield curve control is projected to be eased near the end of the projection period, when inflation reaches its target sustainably, accompanied by stronger wage growth. The latest economic package will also support longer-term growth, with investment in skills, digitalisation and the green transition. Diversifying energy sources, increasing the share of renewables and enhancing the electricity grid would improve energy security.

External pressures are weighing on the domestic demand-driven recovery

The 7^th wave of COVID-19, starting from late June 2022, recorded the highest number of infections and deaths, but no confinement measures were introduced, limiting the impact on economic activity. In addition, border controls for foreign travellers have been gradually eased and were fully lifted in October. However, increasing prices have affected consumer sentiment. Energy and food prices remain the biggest driver of headline consumer price inflation, which reached 3% in August and September. However, cost increases have been only partly passed through into prices, and government measures, such as price caps on oil, have helped keep inflation relatively muted. The labour market has been tightening, but wage growth remains sluggish.

Japan 1

1. Nominal wages are total cash earnings per employee. Real wages are nominal wages deflated by the consumer price index excluding imputed rent.

2. Three-month moving average.

Source: Ministry of Internal Affairs and Communications; Ministry of Health, Labour and Welfare; and OECD calculations.

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Japan: Demand, output and prices

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Japan 2

1. The trade deficit in January 2020 was JPY 0.06 trillion.

2. Gross fixed capital formation.

3. Moving nominal gross fixed capital formation weights, using purchasing power parities.

Source: Ministry of Finance; OECD Economic Outlook 112 database; and OECD calculations.

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While domestic demand is recovering slowly but steadily, external demand has been volatile. Supply chain disruptions arising from Russia’s war of aggression against Ukraine and China’s zero-COVID-19 measures have held back production, investment and exports. Furthermore, widening policy interest rate differentials with other advanced economies have led to additional yen depreciation, adding upward pressures on the prices of imported energy, food and raw materials. The impact of currency depreciation on imports has been larger than that on exports, increasing the trade deficit and decreasing corporate profits and incomes for firms dependent on imports while boosting those of exporting firms. The government has reacted strongly to the shock, with a set of measures worth JPY 3.5 trillion (0.6% of GDP) in September to moderate the price surge and support vulnerable households and businesses. This includes the extension of the subsidy for the oil price cap until the end of December, the freezing of the government selling price of imported wheat at the April level, a one-off special cash benefit to low-income households, and a special grant to local governments to help them support vulnerable households and businesses. Energy security concerns have also given an impetus to the ongoing discussions on putting nuclear power reactors back into service, most of which were suspended after the accident in Fukushima.

Fiscal measures are moderating the impact of external shocks

Some of the measures in the new economic policy package announced at the end of October, such as a further extension of the oil price cap subsidy until September 2023 and the introduction of new schemes to reduce electricity and utility gas bills from January to September 2023 (JPY 6.3 trillion, 1.2% of GDP), aim to moderate prices. The package also includes medium-term expenditures to strengthen local economies, to boost investment in human capital, digitalisation and the green transition, and to bolster economic security. The related supplementary budget will be around JPY 30 trillion (5.5% of GDP), but includes contingency reserve funds and expenditures expected to be implemented over multiple years. Hence, the near-term impact of the subsidies, especially for R&D and investment, is expected to be limited. The OECD projections assume that pandemic-related measures will be phased out, and that the one-off cash benefit will not be renewed, while the main measures for moderating energy and food prices, notably the price subsidies, will remain in place but gradually decline over time. Without additional revenues, the substantial additional expenditures will worsen the fiscal balance, and the debt-to-GDP ratio will continue to increase to unprecedented levels.

Consumer price inflation has exceeded the 2% target for several months and forex interventions have been carried out since September with a view to reduce exchange rate volatility. At the same time, the Bank of Japan announced the continuation of its current accommodative stance, mentioning that recent inflation is driven by external factors and that wage pressures remain weak. So far, yield curve control, maintaining 10-year Japanese government bond yields at around zero within a range of plus or minus 0.25 percentage point, has been kept unchanged. The projections assume that the yield curve control framework will start to be eased slightly, by allowing a steeper slope without changing the short-term rate, at the end of the projection period when the Bank’s criteria on inflation and wage growth will be met.

The economic recovery will continue, but downside risks have risen

GDP growth is projected at 1.8% in 2023, supported by the new economic policy package. Nevertheless, low confidence and real disposable incomes will hold back private consumption. Weak external demand and high import prices will weigh on trade. Despite a fall in confidence and external demand, private investment will substantially increase due to government subsidies, especially those supporting green and digital investment. GDP growth will decline to 0.9% in 2024, which is still above potential. This reflects lower domestic demand, as pandemic-related support is fully phased out, government spending declines and business investment normalises, following the post-pandemic rebound. Headline consumer price inflation will continue to remain elevated until early 2023 due to increasing food prices and higher energy costs, but government support measures will dampen the impact on consumers. As the output gap closes, inflation is projected to increase to the 2% target at the end of 2024. The unemployment rate will continue to decline. Wage growth, while set to remain subdued in the near term, will gain momentum as the labour market tightens.

A key source of uncertainty is the impact on domestic demand of rising inflation from yen depreciation and energy price increases. Weaker-than-expected external demand and further supply chain disruptions due to new COVID-19 shocks or geopolitical uncertainty could threaten energy security and depress trade, production and investment. On the upside, further yen depreciation could strengthen the price competitiveness of exports, including inbound tourism.

Accelerating structural reforms will be critical to boost productivity and wages

If downside risks materialise, further fiscal measures to support vulnerable households and businesses should be temporary and more targeted. Prolonged price caps add to fiscal sustainability challenges and could reduce incentives to shift to renewables and lower energy demand by distorting market signals. Securing and reallocating employment, global supply chains and energy sources are high priorities both in the short and longer term. Continuing “work-style” reforms, expanding social security coverage for non-standard workers, and enhancing vocational training and education could boost labour productivity and labour supply and offset the effects of an ageing population. Lowering barriers to foreign workers and foreign direct investment would also help. Faster progress with the digital and green transformation is needed, which will be supported by the new economic policy package. However, higher permanent government expenditures without additional revenues will worsen fiscal sustainability and threaten sustainable growth. It is important to either set out a clearer roadmap to achieve the fiscal consolidation target by FY 2025 or to reconsider the earlier plan on account of the ongoing crisis and define a new credible target underpinned by a specific set of measures. Fiscal consolidation efforts should resume on both the expenditure and the revenue side, including social security and tax system reforms, as the recovery strengthens. As further rapid changes in economic conditions might trigger a revision to the monetary policy framework, the Bank of Japan should continue to communicate its current and future monetary stance clearly and in a timely manner.