Following up on Japan

A week ago I had a note on the economic outlook on Japan and now, with the recent data, I think it is time to do a whee round up. First of all, the chance (or risk) for an additional hike by the BOJ seems to have dissipated with the recent inflation data showing a -0.1% (overall consumer prices -0.2%)  y-o-y drop in February on the back of a steady (0%) inflation rate in January. The decline was of course widely expected due to the y-o-y deflationary impact from falling energy prices but still it comes at a bad time for the BOJ after having pushed a rate on the basis of Q4 06 GDP figures and general international pressure to normalize interest rates and thus curb the carry trade. Moreover the preliminary data for March also suggest that prices declined -0.1% in. On a brighter spot industrial production 'only' declined 0.2% in February which suggests that Japanese companies won't sustain de-stocking from Q4 06 too much into March and perhaps capex will begin ticking up already in March which again depends on the fundamentals in Japan's major export markets.

On a much more positive note household spending increased 1.3% on a year earlier in February which indeed is good news as this figure is a key indicator for the sustainability and trajectory of the Japanese economy. Moreover, retail sales also showed slight positive signs although they were virtually flat y-o-y. 

So, both good and bad news then but does it change anything from what I said in my last note? Firstly, let us look a bit closer on the outlook for inflation where the always excellent Takehiro Sato serves up the cold facts in a recent note over at MS GEF. The first thing to note is that deflation measured by the core index almost certainly will linger into March as I also noted above but more importantly Sato rolls out an argument and calculations which suggest that deflation will persist on a y-o-y basis much further into 2007 which effectively will stall the normalization process at 0.5%. As such, Sato notes the much pessimistic forecast of a 0.3% drop in the CPI index in Q1 2007 which may even be on the upside. In short, this smells rasther nastily of entrenched deflation in the first two quarters of 2007 save for a major hike in energy prices which are after all trending upwards at the moment. Secondly, we have private consumption and retail sales which show promising signs of a y-o-y improvement in Q1 but what about the fundamentals and the looming entrenchment of deflation? Most notably, the recent Tankan Survey (sorry, no link) also shows that consumer expectations of price increases have fallen back considerably which indicates that consumers probably will hold back spending. This is of course difficult to say and indeed the immediate outlook on demographics reveal that a lot retirees will be up for bonuses soon which means that consumer spending as a function of dissavings might be a trend to look out for but at the end of the if deflation sets in with its nasty grip the fundamentals will indeed be tested. Of course monetary policy is the last part of the equation and here I really do not think we should expect much of a hike although of course the G-7 ministers are still wandering around in wonderland poised to strike once again on the low Yen and the need for the BOJ to normalize.

In summary, I think that the recent signs from the internal demand side proxied by household spending are positive but I am truly worried and not at all happy about the outlook on in(de)flation which I fear will feed strongly into expectations and thus also consumer spending in Q2 2007.