It appears that Abenomics is working fairly well—at least so far. Economic growth in the first two quarters of 2013 was strong. Specifically, real GDP increased at an annual rate of 3.8 percent in the first quarter and 4.1 percent in the second quarter. The strong growth was led by a boost to business investment, itself the result of strong profitability and improved confidence. The likely cause of this acceleration in growth was the expectation of and implementation of the dramatic shift in monetary policy earlier this year. This is the second arrow of Abenomics, the others being fiscal stimulus and deregulation. As for the monetary policy shift, the Bank of Japan began a program of unlimited purchases of assets aimed at boosting liquidity, creating inflation, and suppressing the value of the yen.
So far, this policy has had a notable impact. The growth of the money supply has accelerated (see figure 1); the value of the yen has declined, thereby boosting export competitiveness; equity prices have risen considerably, boosting consumer wealth and potentially having a positive impact on spending (see figure 2); and consumer price inflation is finally positive, which should have a positive impact on the willingness of consumers to spend (see figure 3). Plus, positive inflation lowers the real interest rate, thus boosting investment. Indeed, growth in the first half of the year involved strength in exports, investment, and consumer spending.
Moreover, the third quarter is starting to look strong. In August, Japanese exports increased 14.7 percent from a year earlier—the fastest such growth since 2010. Still, this was not sufficient to reverse Japan’s trade deficit. The latter persists because of rising energy costs—especially as Japan must import energy to offset the continued loss of nuclear power. Exports increased to the United States and China, demonstrating the power of a declining yen. The yen is down roughly 20 percent from a year ago. Other positive signs for the third quarter include strong growth of industrial production and an increase in the purchasing manager’s index (PMI) for manufacturing. On the other hand, one worrisome sign is that wages have not yet budged. If prices continue rising without commensurate increases in wages, then real consumer purchasing power will decline, thereby hurting consumer spending. Indeed, retail sales declined in July from a year earlier, disappointing those who expected continued improvement in the consumer sector.
In August, Japanese exports increased 14.7 percent from a year earlier—the fastest such growth since 2010. Still, this was not sufficient to reverse Japan’s trade deficit.
Despite signs of modest strength, there is a widespread viewpoint that the actions taken so far, while helpful, are not sufficient to generate sustained strong growth. Providing liquidity stimulates spending, but does little to ease bottlenecks and improve productivity. Rather, the third arrow of Abenomics, deregulation, will be needed to truly change the longer-term economic outlook. Yet, that must await specific proposals from the government, which are expected to be announced soon. Although the governing party has a majority in both houses of Parliament, the ability to pass politically difficult legislation is still not certain.
Meanwhile, even the short-term economic outlook is considered uncertain because the national sales tax is set to rise from 5 percent to 8 percent early in 2014. This is due to a law passed prior to the election of the current government. The tax increase, which is set to be followed by another increase from 8 to 10 percent in 2015, is meant to fix the long-term deficit of the country’s pension system. The goal is to address the impact of an aging population and, in the process, stabilize the country’s sovereign debt, which has grown rapidly in recent years. However, there is concern that the tax increase will stymie consumer spending and cause the economic recovery to stall. The last time the sales tax was increased, in 2007, there was a substantial negative impact on consumer spending following the tax increase. Prior to the increase, consumer spending accelerated in anticipation of the tax increase. That could happen in the months ahead.
Some political leaders called for a delay or gradual implementation of the tax increase. They feared that the increase would cause the recovery to stall. Others, however, said that a delay would spook financial markets, leading to higher bond yields and lower equity prices. Moreover, they said that the economy will be strong enough to absorb the shock of a tax increase. Their argument was that the huge increase in equity prices over the past year, by boosting household wealth substantially, will stimulate increased consumer spending. Finally, many political leaders called for offsetting tax reductions and spending increases in order to avoid the negative consequences of the tax increase. Just before we went to press, the government announced it would allow the tax increase to take effect, but it will implement temporary measures aimed at easing the impact. The tax increase is expected to yield about 8 trillion yen in annual revenue. The offsets announced are expected to cost about 5 trillion yen. Among the offsets are early repeal of temporary taxes that were implemented to finance earthquake reconstruction, increased spending on infrastructure, tax incentives for investment and hiring, and tax cuts for lower-income households. In addition, the Bank of Japan has indicated that it is prepared to accelerate asset purchases should the economy show signs of weakening as a result of the tax increase.
Despite signs of modest strength, there is a widespread viewpoint that the actions taken so far, while helpful, are not sufficient to generate sustained strong growth.