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Revised Economic Forecast for Fiscal 2006-2007
(Subsequent to Release of 1st Preliminary QE for October-December)

February 16, 2007

October-December quarter sees rapid growth at annualized rate of +4.8%

The October-December quarter of 2006 saw rapid real GDP growth (1st preliminary quarterly estimates) of +1.2% quarter-on-quarter (equivalent to an annualized rate of +4.8%), well in excess of most forecasts.
Growth on the same quarter in the previous year also returned to the 2-3% range (+2.1%), confirming the fundamental strength of Japan's economy.

A breakdown by elements of demand reveals that the rapid growth over the last quarter was achieved on the strength of (i) growth in consumer spending that made up the sharp fall registered in the July-September quarter (real spending on food recovered to the average level recorded in the first half of 2006, while demand for flat-screen TV sets, game machines and other digital consumer electronics saw a sharp rise), (ii) a temporary slowing of the rate of decline in public investment and (iii) steady growth of capital investment, which together offset the negative impact of the slowdown in exports.

The GDP deflator rose to +0.03% quarter-on-quarter, turning positive for the first time in eight consecutive quarters. (Similarly, change on the same quarter in the previous year was –0.5%, continuing the deceleration of the rate of decline since the October-December quarter of 2005.) A breakdown reveals that, in spite of sluggishness in consumer spending and other areas of the domestic demand deflator, the pause in the upward trend of the price of crude oil (fall in the import deflator) served to boost the GDP deflator.
As a result, nominal GDP was up +1.2% quarter-on-quarter (equivalent to an annualized rate of +5.0%), its first increase since the January-March quarter of the year 2000.

The latest QE, which indicate that consumer spending is steady as an overall trend, that corporate business activity is steady and that real GDP growth for fiscal 2006 is likely to be around 2%, remaining at this level for a fourth consecutive year, against the backdrop of a latent growth rate in the middle of the 1-2% range, are likely to encourage economists to revise predictions that the Bank of Japan will postpone the interest rate hike it has planned for this month, predictions that have been increasingly widespread since the end of January.
Following an initial slowdown, growth is set to accelerate once more in second half of year

Looking ahead, the January-March quarter of 2007 is likely to see a continued gentle deceleration of the Japanese economy, due largely to the export slowdown and production speed adjustments in the IT devices sector.
The real growth rate (annualized quarter-on-quarter rate) is likely to fall to around the same level as the latent growth rate (the middle of the 1-2% range).

However, for the following reasons, the Japanese economy still retains a considerable ability to absorb shocks, and it is unlikely that the recovery trend itself will be disrupted:
(i) Inventory ratios in non-IT sectors are at a low level.
Inventory ratios in the metals and machinery sectors, in particular, are at their lowest ever levels. For this reason, there is little risk of major production adjustments across mining and manufacturing industry as a whole. (ii) The corporate sector is resolving pressures for structural adjustment and is enjoying plentiful money stocks.
With management concerns in the corporate sector shifting from the adjustment of excessive levels of employment, capital equipment and debt to active business development with a view to survival against global competition and the need to secure human resources in preparation against the retirement of the dankai generation of babyboomers and the onset of full-scale population decline, the corporate sector is maintaining its positive stance on capital investment and employment.

Against this backdrop, caught between negative factors such as the corporate sector's efforts to curb the labor share and the increased burden on the household sector on one hand and positive factors such as improving employment conditions and the recovery in share prices on the other, consumer spending is likely to continue to fluctuate for some time.
However, the presence of a number of other factors, including the increasing scope for wage increases due to the pause in the upward trend of crude oil prices, and the impact of the mass retirement of the dankai generation of baby boomers (through a rise in lump sum retirement benefit payments and increased scope for wage hikes for those still of working age), make it highly likely that the above positive factors will gradually become dominant. (In the long term, the trend of consumer spending is likely to be upward.)

Ultimately, even if the economy decelerates in the short term, its basic trend is likely to remain steady. Real growth for the full fiscal year (2006) is likely to be +2.0%. This will be the fourth consecutive year that Japan has achieved 2% growth.
Moreover, if the US economy does achieve a "soft landing", it is highly likely that the pace of growth will pick up once more in the second half of calendar 2007. The real growth rate for fiscal 2007 is likely to be up on the level recorded for fiscal 2006, at +2.3%.

Consumer prices (excluding fresh foods, year-on-year change) are likely to settle into a positive trend as the balance of supply and demand improves.
However, a number of factors, including the low recovery potential of wages, the persistent preference of consumers for lower prices, and a year-on-year slowdown in the growth of petroleum product prices, mean that the pace of consumer price growth is likely to remain slow.

For more information on the content of this report, please contact Makoto Ishikawa , the Japan Research Institute, Limited.

Tel: 03-3288-4263

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