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Japan Economics Viewpoint Bankof America Ready for ignition Merrill Lynch 18 November 2016 Consensus underestimating GDP and inflation poral We are upbeat on Japan’s outlook and think consensus is underestimating the strength of medium-term GDP and inflation. We expect growth of 1.4% in CY2017 and 1.2% in CY2018, well above consensus of just 0.8% growth next year. For the first time in four years both monetary and fiscal policy are supporting growth. The combination of modestly higher commodity prices, a weaker yen, and a tightening output gap should drive Japan-style core inflation to 1.0% in CY2017, and 1.4% in CY2018. We expect the Bo) to keep its rate targets unchanged for the foreseeable future as inflation moves in the right direction. > Izumi Devalier Fiscal and monetary policy realigning For years Japan has oscillated between loose and tight fiscal policy. Japanese policymakers now seem to be on the same page and we see little risk of another policy error. If anything, we see upside risks from greater fiscal stimulus via a third Izumi Devalier supplementary budget or a relatively aggressive FY17 ordinary budget. Meanwhile, the Sea ae ey Bo)’s new interest-pegging regime ensures that financial conditions will become +813 6225 6257 . . . . . . izumi.devalier@baml.com 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 1.5 1.0 0.5 0.0 -0.5 Real GDP %YoY 14 CPI ex fresh food %YoY 14 1.0 CY16 CY17 cy18 CY16 CY17 cy18 mBofAML m= Consensus (Bloomberg, as of 15 Nov 2016) Source: BofA Merrill Lynch forecasts, Bloomberg BofA Merrill Lynch does and seeks to do business with issuers covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Refer to important disclosures on page 13 to 14. 11686430 Timestamp: 17 November 2016 03:00PM EST Unauthorized redistribution of this report is prohibited. This report is intended for amanda.ens@baml.com HOUSE_OVERSIGHT_014410