Japan's GDP Decline and Fragile Business Sentiment Impact Bank of Japan's Rate Hike Timing

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Japan cut its first-quarter gross domestic product (GDP) estimate on Monday, and services sector sentiment worsened in June due to concerns about rising costs.

This overshadowed rising industrial confidence and highlighted weakness in consumption. However, Tankan's quarterly survey showed that companies plan to increase capital spending and forecast inflation to remain at 2% in the coming years. This supports market expectations for a near-term rise in interest rates.

Analysts say the findings ahead of the Bank of Japan's next monetary policy meeting on July 30 and 31 make it difficult to decide whether to raise interest rates soon.

In a rare unscheduled downgrade to Japan's historical GDP data, the economy contracted more in the first quarter than previously reported, which could force the Bank of Japan to revise its growth forecasts for this month.

The Tankan survey also showed that service companies were less optimistic in June compared to March, indicating that weak consumption and a tight labor market are weighing on sentiment.

The sentiment index for large non-manufacturing companies fell to +33 in June from +34 in March, matching market forecasts and worsening for the first time in two years. At the same time, the core sentiment index for large manufacturers rose to +13 in June from +11 in March, beating the average market forecast of +12.

The reading, the highest since March 2022, reflects a recovery in car production and progress in overcoming rising raw material costs through higher prices. Large firms plan to increase capital spending by 11.1% in the current financial year ending March 2025, following a 10.6% rise in the previous year.

The survey also revealed an increase in the output price index for both the manufacturing and non-manufacturing sectors, indicating rising inflationary pressures. Long-term corporate inflation expectations also edged up, with companies predicting inflation to reach 2.3% in three years and 2.2% in five years.

Governor Kazuo Ueda has indicated that further rate hikes are possible if core inflation approaches the 2% target as projected. Many market participants anticipate the Bank of Japan will raise rates again this year, with some expecting it to occur as early as July.