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the BoJ's new interest-pegging regime ensures that financial conditions will become increasingly stimulatory as inflation rises. 2017 - a year of recovering domestic demand We think the economy is heading towards a cyclical sweet spot and see a broad-based recovery in domestic demand. Specifically, 1) consumption is poised to rebound as the saving rate peaks; 2) capex should accelerate in response to the improving demand outlook, deepening supply-side constraints, and "low-for- longer" real rates; and 3) increased efforts by policymakers to accelerate income redistribution could push up the velocity of money at the margin, helping to reflate the economy. Biggest risk factor: US policy uncertainty External developments pose the greatest risk to our forecasts, chief among them US policy uncertainty. The downside scenario for Japan is a combination of rising US protectionism, sliding global trade, and a stronger yen, which could reduce 2017 growth to zero. The Trump presidency may increase pressure on Japan to achieve greater military self-reliance, boosting defense spending. There will also be greater incentives to deepen economic and trade linkages with key regional players, such as China and Russia. Chart 1: We think consensus is underestimating the strength of medium-term GDP and inflation 2.0 Real GDP %YoY 4 4 CPlextreshfood YoY yg oe a 05 0.0 O05 ove Ove ove Cvs OvlT ov1s BBofAML | Consensus (Bloomberg, as of 1& Now 2016) Source: BofA Merrill Lynch forecasts, Bloomberg Izumi Devalier © Japan Economist Merrill Lynch (Japan) HOUSE_OVERSIGHT_014402