Japan's economy slipped into recession and dropped to 4th place in the global rankings

The Japanese economy shrank at the end of last year, defying expectations for moderate growth and plunging the country into recession.

Japan's unexpectedly weak economy in the fourth quarter was the result of a slowdown in spending by businesses and consumers grappling with four-decade high inflation, a weak yen and rising food prices.

The end of the year marked a much-anticipated moment: Japan's economy, now only slightly smaller than Germany's, slipped a notch to become the world's fourth largest.

On an annual basis, gross domestic product fell 0.4 percent from October to December, after a revised 3.3 percent decline in the previous three months. Economists had forecast growth of around 1 percent in the fourth quarter.

The figures cloud the outlook for Japan's economy. Corporate profits are at record highs, the stock market is rising and the unemployment rate is low. But consumer spending and business investment — the two main drivers of the economy — have lagged.

Shinichiro Kobayashi, chief economist at Mitsubishi UFJ Research and Consulting, said the economy was “polarized” because of higher prices. When corporate profits rise, so do the prices of goods, but wages don't, and consumers are reluctant to spend, he said.

A big question is whether Japanese workers can get a meaningful raise in wages this year.

“The ball is in the court of the corporate sector,” Mr. Kobayashi said.

Two straight quarters of negative growth means the economy is technically in recession, but the figures are preliminary. A sufficiently large correction can cancel the recessionary seal.

Soft economic data also complicates the Bank of Japan's upcoming decision on whether to go ahead with the country's first interest rate hike since 2007.

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Japan's central bank has stubbornly maintained policies to keep interest rates low and stimulate spending — a remnant of its long-running battle to fight deflation. Many economists have speculated that the central bank may finally reverse course as early as April if the economy appears to be in a strong position.

Capital Economics' Asia Pacific head Marcel Thilliant wrote in a research note that he was “sceptical” that the disappointing fourth-quarter data would prevent the Bank of Japan from ending negative interest rates in April. year.

A sticking point for the central bank is the persistently weak Japanese yen. As the currency's purchasing power declines, the cost of imports to Japan increases, adding to the inflationary pressure felt by consumers. However, it helps the bottom lines of many leading Japanese companies that sell goods overseas and bring those foreign earnings back home in yen.

The Bank of Japan's policies have exacerbated the yen's weakness by remaining firm over the past two years even as the European Central Bank and Federal Reserve raised interest rates. This has made it attractive for global investors to borrow yen at very low interest rates in Japan and invest in dollars or euros at high interest rates in the West.

Saisuke Sakai, senior economist at Mizuho Research & Technologies, said the domestic economy is likely to contract again in the first three months of the year because of disruptions caused by the massive earthquake that struck western Japan in January – a productive region.

This may further affect consumer sentiment.

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“If we have three quarters of negative growth, the question is, 'Is the Japanese economy really OK?' People will think that,” said Mr. Sakai said.

With the release of its year-end GDP numbers, Japan has relinquished its spot as the third-largest economy behind the US and China, a position it has held since China overtook it in 2010. Germany now holds that distinction in terms of the US dollar, the main currency used in world trade and finance.

Indeed, the German economy is also falling apart. Germany's decision to stop buying cheap Russian natural gas and oil after Russia's invasion of Ukraine has sharply raised energy costs, even as the country has turned to suppliers in the Middle East, the United States and elsewhere.

As its shrinking population struggles to keep up with the growth of the world's most populous country, India, Japan is set to become the No. 4 may lose its grip.

Keith Bradsher Contributed report.

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