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SINGAPORE, March 7, 2024 – The Japanese economy is forecast to grow at a steady pace of 1.1 percent in 2024 after a strong recovery of 1.9 percent in 2023. Near-term external risks include a sharper slowdown in other major economies and a potential spike in global commodity prices due to geopolitical events. On the domestic front, although inflation has moderated somewhat, a key risk in the short term is the resurgence and persistence of inflation at a level well above the central bank’s 2 percent target. Given the increasing risk of high inflation becoming entrenched, it would be prudent for the Bank of Japan (BOJ) to exit from its current ultra-easy monetary policy stance in a timely manner so that monetary policy can play its role in containing inflationary pressure and anchoring inflation expectations at the target level. With the economy recovering robustly, fiscal consolidation should resume after the large stimulus spendings during the COVID-19 pandemic period.

These policy recommendations are highlighted in the 2023 Annual Consultation Report on Japan published by the ASEAN+3 Macroeconomic Research Office (AMRO) today. The report is based on AMRO’s Annual Consultation Visit to Japan which was completed on November 8, 2023, and data and information available up to December 25, 2023.

Recent developments and outlook

The Japanese economy rebounded strongly in 2023 following a full reopening post-pandemic. Private consumption remains resilient despite high inflation. Business investment weakened in Q2-Q3 but is expected to rebound going forward, reflecting ongoing efforts toward digitalization and adoption of labor-saving technologies. Exports have surprised on the upside despite global headwinds.

Consumer price inflation has started to moderate in 2023, primarily due to a decline in energy prices. However, it remains relatively high, as the core consumer price index (CPI) less fresh food rose by 2.5 percent year-on-year in November 2023, staying above BOJ’s price target since April 2022. The core CPI less fresh food is expected to decline gradually but remain elevated at 2.6 percent in 2024 from 3.1 percent in 2023.

Japan’s external position has remained strong in 2023, supported by a large primary income surplus and a steadily narrowing trade deficit. The yen continued to be weak against the U.S. dollar, depreciating by more than 10 percent in 2023, reflecting a divergence of monetary policy stance with the U.S. and other major economies.

Credit growth expanded by over 3 percent in 2023, driven by the resumption of economic activity. The overall banking system remains sound in terms of asset quality, capital buffers, and profitability.

Amid ongoing stimulus spending, strong tax revenue growth played a key role in reducing the fiscal deficit to 3.6 percent of GDP in FY2022 from 5.9 percent of GDP in FY2021. In November 2023, the government announced a supplementary budget equivalent to 2.2 percent of GDP. As a result, the fiscal deficit for FY2023 is now estimated to rise to 5.2 percent of GDP, as fiscal policy remains expansionary.

Risks, vulnerabilities, and challenges

Key risk factors for Japan’s economy in the short term stem mainly from the external sector and risks to growth are tilted to the downside. With Japan’s heavy reliance on energy and raw material imports, an upward spike in commodity prices would be a major shock to its economy, worsening the terms of trade and weighing down domestic consumption. A recession in the U.S. or Europe would adversely affect Japan’s manufacturing and export sectors by dampening demand. Another key risk in the short term is a resurgence of inflation that may lead to an aggressive tightening of monetary policy, with potentially adverse consequences for the economy and financial sector.

Medium to long-term vulnerabilities and challenges include weakening fiscal discipline, side effects of prolonged monetary easing, and the demographic drag caused by population aging and low fertility rates.

Policy recommendations

With Japan’s high inflation persisting longer than anticipated, the BOJ needs to normalize its monetary policy framework in a timely manner so that monetary policy can be used to effectively anchor inflation expectations. The yield curve control (YCC) policy should be phased out to allow long-term interest rates to align more closely with the market, while maintaining the flexibility to intervene to smooth excessive volatility in the bond market. The BOJ should consider moving away from the negative interest rate policy to allow the short-term policy rate to play its traditional role in managing inflation and anchoring inflationary expectations once price stability target is achieved.

The BOJ’s comprehensive review of monetary policy should provide guidance for policymakers to conduct monetary policy so that it can play a more effective role in managing inflation in the post-pandemic era.

As the economy exhibits steady trend growth after the pandemic, stimulus measures are no longer needed. Demonstrating a commitment to fiscal discipline requires adherence to the government’s fiscal consolidation plan to achieve a primary surplus in the medium term. However, stronger steps are required such as specifying expenditure cuts and identifying sustainable revenue sources for emerging needs in areas like defense and childcare. The effectiveness of this process can be supported by the establishment of an independent fiscal institution (IFI).

It is imperative for Japan to undertake comprehensive structural reforms to address underlying economic challenges and unlock its growth potential. To address these challenges, the government should prioritize reforms for improvement of labor market flexibility, encourage continued skill development and training for the workforce, promote greater digitalization, and embrace technological advancements to mitigate the intensifying labor shortages.

Structural reforms in the energy sector are also necessary for adopting more sustainable and reliable energy sources. The government’s efforts toward transitioning to renewable energy are commendable, notably with the approval of the Basic Policy for the Realization of Green Transformation (GX) that outlines a 10-year roadmap to move away from coal-fired to a clean energy society.

About AMRO

The ASEAN+3 Macroeconomic Research Office (AMRO) is an international organization established to contribute toward securing macroeconomic and financial resilience and stability of the ASEAN+3 region, comprising 10 members of the Association of Southeast Asian Nations (ASEAN) and China; Hong Kong, China; Japan; and Korea. AMRO’s mandate is to conduct macroeconomic surveillance, support regional financial arrangements, and provide technical assistance to the members. In addition, AMRO also serves as a regional knowledge hub and provides support to ASEAN+3 financial cooperation.

About AMRO’s Annual Consultation Report

The Annual Consultation Report was prepared in fulfillment of AMRO’s mandate. AMRO is committed to monitoring, analyzing, and reporting to its members on their macroeconomic status and financial soundness. AMRO also helps identify relevant risks and vulnerabilities, and assists members, if requested, in the timely formulation of policy recommendations to mitigate such risks.