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Although Shinzo Abe announced his resignation as Japan’s prime minister, Abenomics will continue. His biggest achievement was bringing economic policy stability through the ‘three arrows’ programme of aggressive monetary policy, expansionary fiscal stimulus and structural reforms.

Mr Abe first resigned as PM for health reasons after a year in office in 2007 but he became Japan’s longest consecutively-serving head of government after starting a second tenure in December 2012. Abenomics was introduced during this latest period, aimed at pulling the economy out of deflation amid a rapidly aging population.

A consumption tax hike from 8 per cent to 10 per cent in October 2019 was quickly followed by the coronavirus outbreak, hitting the Japanese economy hard. Real GDP contracted for three consecutive quarters and the country’s recovery lagged others in the region because of its high exposure in automobiles and global investment.

Japan’s economy thus needs all the support it can get, implying that both monetary and fiscal policy will be firing on all cylinders for the time being. Economic strategy is set to stay the course in the near-term under the new prime minister therefore.

This means the Bank of Japan will focus on maintaining stability in financial markets through enhanced open-market operations, especially with short-term facilities. We expect the central bank to hold interest rates for the foreseeable future as the current negative rate regime limits the pass-through impact of a rate cut.

So fiscal policy is taking the lead to support the economy. The government's primary budget deficit seems set to widen to 11.7 per cent of GDP in 2020 compared with 2.6 per cent in the last fiscal year. Gross issuance of government bonds looks likely to increase to 253 trillion yen (USD2.4 trillion) compared with 155 trillion in 2019.

But there are risks that the economy loses momentum even further as long-term growth and inflation expectations that were built during Abenomics dwindle in future year. Post-war Japanese prime ministers have typically served less than two years and a general election is due before October 2021.

Long-term expectations matter more in Japan than in many other economies. Indeed, despite a relatively large positive output gap in 2017 and 2018, inflation has remained subdued due to the deflation mind-set. Moreover, wage-setting behaviour in Japan is arguably determined by long-term growth expectations rather than current labour-market conditions.

If stability in the macropolicy setting is derailed, there are material risks that the nascent rise in growth and inflation expectations will be lost.

First published 28 August 2020.

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