Japan faces risk of a technical recession

The risk of a technical recession has emerged due to the weakness in recent data. Industrial production contracted 0.5% (MoM sa) in Aug15, the second consecutive month of decline, reflecting the deterioration in exports demand and the increase in destocking pressures. It now looks almost certain that industrial production has shrunk on the sequential basis during the Jul-Sep15 period. Whether GDP growth could avoid a contraction in 3Q15 largely depends on the services sector, the output of which is primarily driven by domestic consumption demand. The risks here are also on the downside. Retail sales growth came to a halt in Aug15, suggesting that consumer spending may have also lost momentum. If GDP growth turns out to be negative in 3Q15, it will be the second consecutive quarter of contraction, matching the definition of a technical recession. This will also be the second technical recession over three years since PM Abe took office in end-2012. 

Having said that, some signs suggest that recession will only be technical rather than genuine. Manufacturing and services PMIs held up well above the neutral mark of 50 in 3Q15. This was different from the below-50 readings seen in the 2008, 2011 and 2012 downturns when the economy was respectively hit by the global financial crisis, domestic earthquake disaster and European debt crisis. Meanwhile, surveys for manufacturers' production plans showed that output will pick up by 0.1% in Sep15 and rise more notably by 4.4% in Oct15, which still suggests the possibility of a recovery in economic activities in 4Q15. 

Weaker-than-expected data have fueled the speculations that the Bank of Japan will further ease monetary policy to support the economy. An immediate policy response is not expected from the BOJ. During the latest speech this week, Governor Kuroda sounded very confident about the inflation outlook, describing the current inflation trend as "robust and improving". For now, it is true that the core-core CPI has continued to pick up as the labor market is tight and the passthrough effects of yen depreciation remain in place. This should provide some leeway for the BOJ to stand pat - unless growth weakness persists and the underlying inflation dynamics are disrupted in the coming quarters. Note that the BOJ looks at the prices trend from a long-term perspective and pays close attention to the future inflation rate expected by enterprises and consumers. 

Also note that Kuroda's rhetoric on the yen has changed a bit. At a meeting this week, he said that a weak yen affects various entities differently, acknowledging that yen depreciation benefits exporters but also hurts importers and consumers. This departs from his remarks last year - a weak yen was positive for the Japanese economy as a whole. With the yen already falling to a three-decade low on the REER basis, policymakers may find it necessary to consider the side effects of excessive currency weakness. Given the potentially mixed impact on the yen exchange rates as a result of Fed rate hikes and China's slowdown, the BOJ would want to wait for a while to see some clarity in global financial markets before taking actions on its monetary policy.