Japan primed for release of third arrow of Abenomics

Last April, Japan's government implemented a long-planned consumption-tax hike, from 5 per cent to 8 per cent, and is expected to bring the rate to 10 per cent by 2015. The hike - a key feature of "Abenomics", Prime Minister Shinzo Abe's three-pronged strategy to revive Japan's economy - signals the government's commitment to fiscal consolidation. But it has also dealt Japan a heavy macroeconomic blow.

Preliminary gross domestic product data shows a 6.8 per cent contraction year-on-year in the second quarter - the largest since the 2011 earthquake and tsunami that devastated the country. Moreover, consumer spending has fallen.

But it is not all bad news. Expansionary monetary policy - the second of three so-called "arrows" of Abenomics, after fiscal stimulus - has brought down the unemployment rate to just 3.8 per cent. The ratio of job openings to applicants has exceeded parity.

Such data has given rise to two opposing views. Some economists worry that negative second-quarter data will dampen inflation expectations, thereby undermining Abe's plan for boosting growth. Meanwhile, the Bank of Japan is emphasising the positive outcomes of its monetary policy - and is hesitating to continue its expansionary measures.

If the first view proves correct, the BOJ will need to ease monetary policy further to counter falling inflation. If the BOJ is right, it should maintain its current approach, while the government should either postpone the next consumption-tax increase or implement it in two 1 per cent increments.

Of course, no decision should be made until the third-quarter results are released, providing a clearer picture. Fortunately, that is what Abe intends to do.

In any case, the success of monetary policy is difficult to deny. As the deflation gap narrows, however, the impact of monetary policy will weaken.