Japan's Business Sentiment Edges Up, Global Risks Cloud Outlook

Japan’s business sentiment saw a slight improvement in the three months leading up to December, according to the Bank of Japan's latest quarterly survey. This positive shift in sentiment bodes well for the central bank’s plan to gradually raise interest rates from near-zero levels. The survey results, released on Friday, reveal that while large manufacturers saw a modest uptick in confidence, non-manufacturers also maintained an optimistic view of business conditions. However, concerns over rising raw material and labor costs were beginning to weigh on retailers' morale.

The survey, which was released ahead of the Bank of Japan's two-day policy meeting next week, highlights an intensifying labor shortage that has become a growing challenge for companies, potentially limiting economic growth. Despite these concerns, large manufacturers were generally positive about their business outlook for the quarter. The headline index for business confidence among major manufacturers stood at +14 in December, slightly up from +13 in the previous quarter and marking the highest reading since March 2022. This figure exceeded the market’s median forecast of +12. The improvement was attributed to a rebound in auto production and sustained demand for capital equipment, as companies increased capital expenditure.

Despite this overall improvement, business sentiment in some sectors, such as retail, hotels, and restaurants, deteriorated. These industries struggled with recruitment challenges and rising labor and raw material costs. Smaller non-manufacturers, however, experienced improved sentiment, reaching levels last seen in 1991. The survey indicated that these companies benefited from the pass-through of rising costs, which boosted profits. This suggests that Japan may be experiencing sustained price increases, a key condition set by the Bank of Japan for further interest rate hikes.

Looking ahead, however, businesses expect conditions to worsen over the next three months. Concerns about soft global demand, potential tariffs under the U.S. administration, and the persistent challenge of high operating costs have clouded the outlook for many companies. Companies are now forecasting an 11.3% increase in capital expenditure for the fiscal year ending in March 2025, slightly higher than the 10.6% projected in the previous survey. Additionally, companies expect inflation to remain above the Bank of Japan’s 2% target in the coming years, reinforcing the conditions necessary for future rate hikes.

As Japan’s economic recovery continues to take shape, the Bank of Japan is closely monitoring these developments. The central bank ended negative interest rates in March and raised its short-term policy rate to 0.25% in July, signaling that the country is making steady progress toward achieving its inflation target. Governor Kazuo Ueda has indicated that the central bank will continue raising rates if businesses remain optimistic and wages and prices continue to rise, helping to keep inflation around the 2% target.