Annualized growth of +2.0% in July-September quarter

The July-September quarter saw real GDP (1st preliminary QE) growth of +0.5% quarter-on-quarter (equivalent to an annualized rate of +2.0%) — positive growth for a seventh quarter in succession. The pace of growth accelerated slightly as compared with the April-June quarter (annualized growth of +1.5%), confirming the continuation of the recovery trend.

By demand category, the growth over the July-September quarter has been led by corporate sector activity, in the form of (i) exports supported by growth of overseas demand and a fall in the value of the yen (up 2.7% on the previous quarter)*1 and (ii) capital investment, including major projects in the transportation sector (up 2.9% on the previous quarter).
By contrast, consumer spending has fallen on the previous quarter (by 0.7%) against a backdrop of sluggish wage growth, inclement weather and the softening of share prices during the summer*2.

*1: The pace of export growth, which had slowed during the April-June quarter, recovered. The slow pace of exports of production goods to Asia against the backdrop of a deceleration in the US economy was offset by the higher pace of growth of exports to the resource-exporting nations. Although shipments of capital and production goods to the United States appeared to peak, shipments of automobiles continued to grow and, if anything, overall growth exceeded that recorded in the April-June quarter.

*2: Slow consumer spending exerted upward pressure on private sector inventory investment and downward pressure on exports (−0.1% on the previous quarter) (both exerting upward pressure on the growth rate). However, a considerable part of the rise in private sector inventory investment in the July-September quarter (which contributed +0.3 points to the quarter-on-quarter growth rate) was due to active accumulation of inventory, especially in the IT sector, and should by no means be seen in a negative light.

Furthermore, the downward trend of the GDP deflator slowed, as compared with the April-June quarter, to –0.8% on the previous year.
A breakdown of the figures reveals that although the import deflator continued to rise at a double-digit rate (+11.7% year-on-year, exerting downward pressure on the GDP deflator), the domestic demand deflator turned positive for the first time since the October-December quarter of 2004 (+0.1% year-on-year).

The latest GDP statistics, which show the Japanese economy continuing to recover and the deflationary mood steadily receding, do not eliminate the possibility of an interest rate increase within the year.

Growth is likely to start to settle to a sustainable pace in FY 2006 before accelerating once more in FY 2007 under the positive influence of a recovery of the US economy and the retirement of the dankai generation.

Looking to the future, the October-December quarter is likely to see slower growth than the July-September quarter owing to, among other factors, the impact of the deceleration of the US economy beginning to make itself felt in earnest (in the form of a slowdown in exports), an adjustment in production speed in the IT sector, centering on electronic components and devices, and the expected tailing-off of the surge in capital investment in conjunction with large-scale projects.
The January-March quarter of 2007 is expected to see the gentle deceleration of growth continue.

Nevertheless, two factors suggest that the Japanese economy is likely to retain a considerable ability to absorb shocks (a different scenario from those observed during the "plateau" phase of 2004 or at the time of the collapse of the high-tech bubble):

(i) The shipments-inventory balance in non-IT sectors is improving Even if pressure for adjustments arises in the IT sector, the non-IT sectors will underpin demand and it is likely that a major production adjustment across all sectors of industry can be avoided.

(ii) The corporate sector is resolving pressures for structural adjustment and has 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 "securing human resources in anticipation of the retirement of the dankai baby-boomer generation and full-scale population decline, the corporate sector is likely to maintain its positive stance on capital investment and employment for a little while longer.

Under these conditions, consumer spending will remain prone to fluctuation due to the continued sluggish growth of wages, poor weather and the trend of share prices, but, as a general trend, is likely to hold its ground thanks to the improvement in employment conditions and the recovery of share prices reflecting the strength of business profits.

Ultimately, the remainder of fiscal 2006 is likely to see the Japanese economy adjusting its speed and settling into a more sustainable growth trajectory while continuing to set fresh records for the duration of a recovery phase. The quarterly pace of growth is likely to remain at a level around that of the latent growth rate, which is expected to be between 1.5% and 2.0%, and the real growth rate for the fiscal year as a whole is likely to be around 2.3%.

In fiscal 2007, the recovery of the US economy and the boost to corporate profits provided by the mass retirement of dankai generation baby boomers (through increased consumer spending on the strength of a rise in the payment of lump sum retirement benefits and through a fall in personnel costs) will have an increasingly positive effect on the economy. Under these conditions, it is likely that the growth rate will accelerate once more as the second half of the fiscal year approaches, and that growth for the fiscal year as a whole will reach the middle of the 2-3% range.

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 natural resource prices, mean that the pace of consumer price growth is likely to remain slow.

*The risk factors inherent in the main scenario depicted above are that the deceleration of the US economy will become severe and that the production adjustments in the IT sector will increase in scale. Caution is required for the very reason that, should the results of the year-end sales campaigns in Japan and the United States fail to live up to expectations, the second half of fiscal 2006 may well turn into a "third plateau phase".

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

Tel: 03-3288-4263
E-mail：ishikawa.makoto@jri.co.jp

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