TOKYO Japan's economy is expected to rebound this quarter from a steep contraction, but looming challenges will keep the pressure on the government and central bank for action to sustain growth.
Economists expect annualized growth of about 4 percent for the three months to September after data on Wednesday showed that an April sales tax hike pushed the world's third-biggest economy into a 6.8 percent drop in the second quarter.
The worst decline since the 2011 earthquake and tsunami highlights the growing gap between the bullish Bank of Japan and skeptical financial markets, even though it did not derail the BOJ and government scenario that the economy is recovering moderately and will not push the central bank into immediate action.
With exports disappointingly weak, inventories building, consumption sluggish and capital spending in question, the central bank may find it harder to argue that its massive stimulus will pull Japan out of 15 years of deflation.
Pressure could also build on Prime Minister Shinzo Abe in coming months to veto a planned further tax hike.
"We can't ignore the effect the big economic contraction in April-June has on the BOJ's economic and price projections," said Naomi Muguruma, senior market economist at Mitsubishi UFJ Morgan Stanley Securities.
Even after trimming its forecasts last month, the BOJ expects expansion of 1.0 percent for the fiscal year through March, well above the 0.3-0.5 percent expectations of private economists. None of the analysts in Reuters surveys over recent months, moreover, expect the BOJ will reach its goal of 2 percent inflation next fiscal year.
BOJ Governor Haruhiko Kuroda has been relentlessly bullish, sticking to his inflation target last week on the grounds that a positive cycle - strong corporate profits boosting business investment and wages, thereby supporting personal spending - remains intact.
Many economists, such as Muguruma, expect the central bank will have to cut its GDP forecast in a half-yearly assessment on Oct. 31, nudging it into expanding its enormous purchases of government bonds and other assets. Others believe the BOJ will not be forced into action given that labor markets are tightening and business sentiment is holding up.
The second quarter's contraction more than erased a January-March surge of 6.1 percent in a spending spree ahead of the April 1 increase in the sales tax to 8 percent from 5 percent.
Averaging the two quarters, the economy grew at better than a 2 percent annual rate in the first half.
"Public-works spending will support growth, while rising summer bonuses will underpin household spending," said Kyohei Morita, chief economist at Barclays Capital Japan. "Our main scenario is for the economy to stage a substantial rebound in July-September."
Morita does not expect a BOJ easing anytime soon, even if the central bank cuts its economic forecast. The BOJ will remain bullish on inflation, he said, as it focuses on economic growth catching up with its longer-term potential. Kuroda has said this output gap has essentially disappeared.
MORE THAN TAX HIKE PAIN
Still, obstacles to recovery remain.
Machinery orders, an indicator of companies' plans for investment in plant and equipment, fell the most in the second quarter since the last global financial crisis, government data showed Thursday, with only a modest rebound forecast for this quarter.
The first drop in orders in five quarters, capped by an unexpectedly weak June bounce, casts doubt on policymakers' hopes that business investment will help drive the recovery.
Exports, which the BOJ was counting on to bolster the economy through the tax-induced consumption decline, have fallen unexpectedly for two months in a row. Some BOJ officials warn that exports may not grow much as many Japanese companies have shifted production overseas, and demand in emerging Asian markets lacks vigor.
Japan's industrial production in June posted its worst drop since 2011 in June, and Wednesday's GDP data showed a worrying overhang in inventories, which could weigh on the expected rebound in factory output.
There are also signs the slump in consumption may be prolonged. Households may be holding back on spending not just because of the temporary pinch from the tax hike but also because wages are not keeping up with inflation.
Households had been expected to cut spending on big-ticket items in the second quarter, but the data showed they also cut back on semi-durable goods and even groceries and other daily necessities.
Employee compensation fell 1.8 percent in the quarter from the previous three months in inflation-adjusted terms, clouding expectations that rising wages and income will support consumption ahead.
"Because consumption fell so much last quarter, the rebound in the current quarter will seem strong because of a low base of comparison," said Norio Miyagawa, senior economist at Mizuho Securities Research and Consulting.
"However, the underlying trend is not that strong," he said. "The decline in real wages in the second quarter was quite big, and spending on non-durable goods was weak. This is more than just a pullback after the sales tax hike."
(Additional reporting by Stanley White and Tetsushi Kajimoto; Editing by William Mallard and Eric Meijer)