OREANDA-NEWS. Abenomics has met with initial success. Strong coordination between the Bank of Japan’s (BoJ) unprecedented quantitative and qualitative easing program and fiscal stimulus combined with ambitious structural reforms helped narrow the large output gap, reversed the undue appreciation of the yen, eased financial conditions, boosted corporate profits, and lifted actual and expected inflation into positive territory. The first consumption tax hike locked in considerable fiscal savings. The economy reached full employment and modest, but historically significant, increases in base wages took hold.

But the recovery and progress with reflation stalled. Headline inflation fell back into deflationary territory, dampening base wage growth. Growth dropped towards potential, with consumption and investment remaining sluggish, amid declining sentiment. The yen appreciated in recent months, equity prices declined, and inflation expectations fell anew. Several factors explain the difficulties in achieving sustained lift off:

  • Structural impediments: Low confidence in economic prospects, related to an aging and shrinking population, is holding back investment and credit demand, constraining portfolio rebalancing. Labor market duality and inflexibility are clogging the pass-through from a tightening labor market and high profits of large firms to wage increases. Weak demand and a lingering deflationary mindset are reducing the ability of firms to raise output prices. The financial sector does not sufficiently support risk taking, limiting access to risk-based capital, as suggested by high reliance of banks on fixed asset collateral and slow restructuring of non-viable SMEs.

  • Policy shortcomings: The fiscal stance turned out to be too contractionary in 2014, over and above the anticipated consolidation due to the consumption tax hike. The stop-go nature of fiscal policy, with yearly supplementary budgets, discretionary changes in consumption tax hikes, and optimistic growth assumptions underlying medium-term budget projections have left fiscal policy without a credible medium-term anchor and are contributing to policy uncertainty. Weak monetary transmission, sluggish wage-price dynamics, and a falling natural rate of interest are preventing the needed rise in inflation expectations, creating a communication and credibility challenge for the BoJ. Structural reform efforts did not sufficiently address the above-mentioned structural impediments, notably in the labor market.

  • Global weakness and volatility: Sluggish global growth and overcapacity in the traded goods sector, prevented the weaker yen from materially boosting exports. Concerns in emerging markets and revisions to the expected path of monetary policy in advanced economies led to heightened volatility in financial markets and safe haven appreciation pressures. Declining commodity prices did not boost activity as expected, but instead put downward pressure on headline inflation and forced the BoJ to repeatedly push out its timeline for hitting the inflation target.

Recent policy actions are aiming to put Abenomics back on track.

  • Negative Interest Rate Policy: The adoption of the negative interest rate policy (NIRP) amid a weakening of the outlook and higher global uncertainty reinforced the BoJ’s commitment to its inflation target and added another tool to the policy framework, allowing it to be more open ended. So far the NIRP has been successful in lowering the entire yield curve and has not adversely impacted market functioning, beyond expected effects on JGB liquidity and bank profitability. More time is needed to see its full transmission to the real economy.

  • Increased fiscal support: The authorities’ decisions to adopt and formulate additional stimulus packages and to postpone the scheduled 2017 consumption tax hike by two and a half years demonstrate the challenge of simultaneously stimulating the economy and moving towards fiscal sustainability in a short timeframe. While these decisions will reduce deflation risks and support near-term growth, they will likely affect the achievement of the authorities’ medium-term fiscal target, unless abrupt consolidation takes place, which would again undermine reflation prospects.

  • Policies to boost wages and investment: The government has been rightly calling for higher wage increases through the tripartite dialogue and recently announced a floor of 3 percent on annual minimum wage increases. The government also cut the statutory corporate income tax rate below 30 percent in FY2016, one year earlier than scheduled, but so far no discernible impact on investment can be observed.

  • New three arrows: Although specific and sufficiently ambitious measures remain to be largely identified, the new “three-arrows” strategy adopted by the government has commendable objectives: (i) a strong economy, with a target of raising nominal GDP to 600 trillion yen; (ii) childcare support to lift the fertility rate and labor force participation; and (iii) a social security system to allow people to continue employment while providing nursing care to family members.

Nonetheless, the growth outlook remains subdued. Japan’s economy is expected to grow at a moderate pace of about 0.5 percent in 2016, before slowing to 0.3 percent in 2017, excluding the possible effect of the yet to be adopted supplementary budget. Private consumption is projected to grow modestly, underpinned by lower commodity prices, targeted fiscal transfers, and rising labor force participation, while nominal wage growth is expected to remain sluggish in the near-term. Weakness in the global recovery and trade, higher uncertainty and the recent appreciation of the yen are expected to pose a drag on net exports and investment. The labor market is projected to remain tight with the unemployment rate remaining close to its structural level of about 3 percent. Over the medium-term, prospects are likely to be hamstrung by the demographics-induced decline in potential growth.

Inflation is expected to remain well below the BoJ’s 2 percent target under current policies. Core inflation is projected to decline in the near-term, reflecting exchange rate appreciation and weak demand. The declining trend in inflation expectations and the deceleration of base wage growth will also dampen inflation dynamics. Headline inflation is projected to remain at about 0.2 percent in 2016 and rise to 0.6 percent in 2017, supported by energy price developments. Inflation is expected to rise gradually in the medium-term with the narrowing of the output gap and slowly strengthening wage-price dynamics.

Downside risks dominate in the medium-term. Risks to the near-term outlook are tilted to the upside—a likely large fiscal stimulus package in 2016-17 provides upside, while external factors including a sharper-than-expected moderation of growth in China, weaker growth in advanced economies and Brexit could have adverse effects. However, the medium-term is subject to important downside risks related to weak domestic demand, uncertainty about the sustainability of low interest rates in a high public debt environment and financial stability risks in the context of unprecedented unconventional monetary policies. These risks can result in stagnation, where doubts about long-term fiscal sustainability could lead to higher sovereign risk premiums, forcing abrupt further fiscal adjustment with adverse feedback loops to the financial system and the real economy.