Two challenges remain for Bank of Japan despite stronger-than-expected GDP

Japanese GDP growth slowed to 0.4% quarter-on-quarter (q/q) in the second quarter, but beat expectations of a more pronounced slowdown.

Although overall growth slowed, under the surface the composition of growth showed an improvement from the second quarter.

Domestic demand improved, contributing 0.7 percentage points (pp) to growth (from 0.1pp last quarter). The major drivers of domestic demand - household consumption and private-non residential investment (capex) - both picked up over the quarter, contributing 0.3pp and 0.2pp, respectively. Government spending also helped boost growth.

Meanwhile, net exports were a drag of 0.3pp to growth. This was driven by an improvement in imports – consistent with stronger domestic demand - although exports alone did fall.

Stronger domestic demand is encouraging at a time when investors question the ability of the Japanese economy to withstand the upcoming hike in value added tax (VAT). The report will be welcomed by the Japanese government, who still look set to press ahead with the tax hike in October.

While the Bank of Japan (BoJ) will likely breathe a slight sigh of relief following the report, this does not fundamentally change the BoJ’s two main concerns: downside risks to the external outlook and currency appreciation. With both of these factors worsening in recent weeks, the BoJ will continue to seriously examine tools for easing monetary policy.