May 18 2017, 12:00 JST

Growth streak provides fresh hope for reflation

According to the Cabinet Office, Japan's Real GDP grew by 0.5% quarter on quarter (QoQ) in the first quarter of 2017. This marked the expansion in the economy for the fifth straight quarter, a remarkable growth streak that had not happened since 2006 . On annualized terms, Real GDP grew by 2.2% as per the preliminary estimate, well higher than Japan's potential annual growth rate considered to lay between 0 to 0.5%.

Japan's growth in the first quarter of 2017 was also well-balanced, supported by both domestic demand and by export demand. Private consumption rose by 0.4% QoQ after coming in flat in the previous quarter. Residential investments and non-residential capital investment also recorded positive growth, although their contribution to the overall growth was negligible. Exports grew by 2.1% QoQ, helped by renewed strength in exports to China and a weak yen. By contribution to the overall 0.5% GDP growth in the quarter, private consumption contributed by 0.2% point and net export contributed by 0.1% point.

The high growth in the quarter is encouraging. According to the BoJ's estimate, the output gap, the difference between the potential growth and the actual output was a positive 0.6% as of the last quarter of 2016. The high growth in the first quarter of 2017 will further push up the output gap, potentially helping to form an inflationary pressure within the Japanese economy. BoJ Governor Kuroda often points to output gap as the most critical indicator to watch.

On the other hand, it is important to note that there is a considerable lag between the rise in the output gap and inflation. In 1989, the output gap had to rise to 2% and stay there for more than a year before the domestic deflator started rising. If the same lag applies to the contemporary Japan, the Japanese economy needs to maintain the pace of 2% annual growth for another 2 years before we start to see a rise in inflation. While the 5 quarters growth streak in the Japanese economy gives fresh hope for Japan to achieve its reflation goal, Japan is only half way on the road to reflation and policy mistakes could easily derail Japan from this path.