Japan Downgrades Economic Growth Outlook as Takayama Cabinet Faces Geopolitical and Inflation Challenges

The Japanese government downgraded its economic growth forecast for the current fiscal year on Thursday (30th), reflecting that rising oil prices due to tensions in the Middle East are suppressing domestic demand. This move further increases the pressure on Prime Minister Takayama to address rising living costs amid inflation.

According to a report released by the Cabinet Office on Thursday, Japan has revised its real GDP growth forecast for fiscal 2026 from 1.3% down to 0.9%. The report notes that while wage growth and policy support may partially offset the impact, high oil prices are expected to weigh on economic activity. Additionally, the forecast for private consumption growth has been reduced from 1.3% to 0.9%, while inflation expectations have been raised from 1.9% to 2.2%.

On fiscal health, the primary balance deficit for fiscal 2026 is projected to widen to 1.2 trillion yen, as additional budget measures offset gains in tax revenue.

Following U.S. military retaliation against Iran and the FOMC's decision to hold interest rates steady, the yen fluctuated around 163.5 per dollar. Market analysts point out that safe-haven demand driven by geopolitical tensions is supporting the dollar, while inflation concerns in Japan have triggered bond sell-offs, pushing the 10-year JGB yield up to 2.805%.

In the stock market, while semiconductor-related stocks rose on strong corporate earnings, overall market sentiment remains cautious about the AI-driven rally, leaving the Nikkei average struggling to gain upward momentum.

To alleviate public dissatisfaction over wages failing to keep pace with inflation, Prime Minister Takayama has proposed reducing the consumption tax rate on food to 1% starting April next year for a two-year period. While this policy aims to ease the cost of living, it also intensifies pressure on the bond market.

In contrast to the government's cautious stance, the Bank of Japan (BOJ) maintains a relatively optimistic outlook on the economy and may discuss upgrading its economic forecasts at its upcoming policy meeting.

Looking ahead, the government remains ambitious, targeting nominal GDP of nearly 1,100 trillion yen and private capital investment of around 240 trillion yen by fiscal 2040.

Market focus is now on the upcoming BOJ meeting outcome, as its hawkish or dovish stance will determine the next moves for the yen and the yield curve.