On April the 1st, the Japanese VAT rate will raise by 3%, from 5 to 8%. Economic activity will slow down, during the 2nd quarter, in response to this negative shock. Households whose expenditures have not been very dynamic in February (-1.5%) will probably be stronger in March before an expected large drop in April with the new VAT rate.

Three issues have to be taken into account to understand the situation

The first one is the exit from deflation. Shinzo Abe wanted to converge to an inflationary environment in order to change behaviors. As the chart shows it, this has been a success. Inflation rate in February was at 1.5% and the core inflation rate was at 0.7%.

Employees noticed the higher inflation rate but nominal wage has not compensated this increase; they have lost purchasing power. The absence of indexation has penalized consumers. We can see the divergence between nominal and real wage in the chart below. There is a rapid and strong divergence since mid-2013. The real wage is decreasing and nominal wage is just positive but not as high as the inflation rate.
A low real income is not a strong incentive to spend. The new VAT rate will be seen in a higher inflation rate and a new negative shock for households and their purchasing power. Consumption momentum will slow down in April and probably during the whole second quarter.
With this in mind, we can understand why economists and the Japanese government have asked for higher wages. It was just a way to compensate for higher inflation rate.
A measure on companies’ tax rate will not be sufficient to reduce significantly the VAT impact.

Households have this sequence in mind. Now there is mistrust in Abe’s strategy.
We can see that on the chart below. Households were enthusiastic when Abe was elected in December 2012. The confidence index jumped to a six-year high. But as soon as inflation rate has increased, confidence dropped. It is now below the level prior to the election.

The impact of the VAT hike on consumers’ behavior has been clearly anticipated by companies. The Tankan survey that was published last night (Paris time) clearly shows negative expectations for the 2nd quarter of 2014.

In Abe’s strategy there was a third arrow: structural reforms. It’s really time to use it in order to make the forthcoming slowdown only a temporary one.