October-December quarter likely to have seen annualized growth of 4.0%

Statistics for the October-December quarter of 2006 (first preliminary QE due to be published on February 15) are likely to show that Japan's real GDP increased for an eighth consecutive quarter, rising by 1.0% on the previous quarter (equivalent to an annualized rate of 4.0%), the largest quarterly increase since January-March 2004.

The rapid growth over this last quarter is partly due to the continued growth of capital investment, but the main causes are (i) the reaction to the sudden fall in consumer spending that occurred during the July-September quarter and (ii) a temporary slowing of the decline in public investment.

Moreover, as the figures are likely to show that (i) the annualized average rate of real growth on the previous half year in the second half of 2006 (July-December) was +1.7%, down from +2.2% in the first half of 2006, and (ii) real GDP growth on the same quarter in the previous year was +1.7% in the October-December quarter, virtually unchanged as compared to the +1.6% rate recorded in the July-September quarter, so that, although the highest "instantaneous wind speed" for some time has been recorded, it seems fair to conclude that the Japanese economy, while maintaining its fundamental strength, has entered a gentle deceleration phase.

Movements of the major elements of demand and the GDP deflator

(1) Consumer spending (real: +0.8% on previous quarter, +3.3% annualized)

The statistics are likely to show that consumer spending has rebounded from its 0.9% quarter-on-quarter fall during the July-September quarter and avoided an outright slump. Although wage growth remains slow, the improvement in employment conditions, the recovery of share prices and the better weather conditions since the summer appear to have had a positive impact on household propensity to spend.
By area, spending on services (travel, communications, etc.) has remained steady, while the growth of spending on flat-screen TV sets and other digital consumer electronics has accelerated. Real spending on food, which fell sharply in July-September quarter as a result of the steep rise in fresh food prices (due to poor weather conditions), recovered, during the October-December quarter, to the average level recorded during the first half of 2006.
However, the warm winter has had a negative impact on some areas, including clothing and heating equipment. With households growing increasingly conscious of spending priorities, there is considerable variation in sales performance between business sectors.

(2) Capital investment (real: +1.8% on previous quarter, +7.3% annualized)

The statistics are likely to show that, although growth has slowed as compared with the first half of 2006, which saw a concentration of large-scale projects, capital investment has continued to grow against a background of firm business performance, continued improvement of capital investment efficiency and plentiful money stocks. The figures are likely to show that capital investment has increased by 10.2% on the same quarter in the previous year, recording its first double-digit rise since the October-December quarter of 2000.

(3) Public investment (real: +1.2% on previous quarter, +5.0% annualized)

The statistics are likely to show that public investment, while recording a double-digit fall on the same quarter of the previous year ( 11.9%), saw positive growth quarter-on-quarter as a reaction to the unprecedented slump recorded over the last two quarters (annualized rates of -25.0% and -19.7%).

(4) Net Exports (real contribution to growth on previous quarter: +0.1 points, annualized contribution: +0.3 points)

The statistics are likely to show that, although exports have continued to grow on the strength of rising demand for Japanese cars in markets around the world, including the United States, and the very strong performance of exports of production goods (especially IT-related devices) to China, the pace of growth has slowed as the effects of the deceleration of the US economy have begun to make themselves felt (+1.2% on previous quarter, +5.1% annualized).
Incidentally, the statistics are also likely to show that, in terms of change on the same quarter of the previous year, export growth peaked in the January-March quarter at +13.0%, and since then has slowed with each successive quarter. It is likely that the figures will show export growth of +6.9% for the October-December quarter.
Meanwhile, although the nominal value of imports has fallen quarter-on-quarter, the downward trend of the deflator, largely owing to the fall in the price of crude oil ($70.6/barrel in July-September $60.6/barrel in October-December) has boosted their real value (+1.0% real change on previous quarter, +4.2% annualized).
As a result, the contribution of real net imports (exports imports) to quarter-on-quarter growth has fallen from the +0.4 points (+1.7 points annualized) recorded in the July-September quarter.

(5) GDP deflator (+0.4 points on previous quarter, -0.2 points on same quarter in previous year)

The statistics are likely to show that the GDP deflator has risen quarter-on-quarter for the first time in 8 quarters.
This is due partly to the fact that the domestic demand deflator is bottoming out, especially in construction-related sectors (+0.1% on the previous quarter), and partly to the fact that the import deflator has turned negative for the first time in 7 quarters (-1.5%, contributing to the rise of the GDP deflator). As a result, the statistics are likely to show nominal GDP growth for the October-December quarter of +1.4% on the previous quarter (+5.7% annualized), reaching a record "instantaneous wind speed" (+1.5% on same quarter in previous year).

If the GDP statistics for the October-December quarter are in line with the Institute's forecast, confirming that the risk of a slump in consumer spending is receding, that business activity remains vigorous, and that the downward trend of the domestic demand deflator has come to an end, they will tend to support the argument for the Bank of Japan to raise interest rates in February.

However, the January-March quarter of 2007 is likely to see a continued deceleration of the Japanese economy, as the slowdown among overseas economies begins in earnest, production speed is adjusted in the IT device sector and wage growth remains sluggish (with little or no sign of acceleration in consumer spending), and the real growth rate is currently expected to slow to the middle of the +1-2% range.

Although the fact that the corporate sector's stance on capital investment and employment is likely to remain positive, and that automobiles, steel and other non-IT sectors are increasing production while maintaining a good balance of inventory and shipments, means there is little risk that the economic recovery is unlikely to collapse, it is likely to be some time after the middle of 2007, after it has been confirmed that the US economy has achieved a soft landing and after the effect of the mass retirement of the dankai generation of baby boomers (the boost to consumer spending provided by the rise in the volume of lump sum retirement benefit payments, etc.) has begun to kick in, that the pace of growth begins to show signs of accelerating once more.

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

Tel: 03-3288-4263
E-mail：matsumura.hideki@jri.co.jp

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