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Following a trade-induced slowdown in late 2011, public reconstruction spending in response to the Great East Japan Earthquake will help boost growth to around 2% in 2012. As reconstruction outlays wane, the expansion will be supported through 2013 by a pick-up in exports. Deflation is likely to diminish, although the unemployment rate will remain above its pre-2008 crisis level.

A budget deficit of around 10% of GDP (excluding one-off factors) in 2012-13 will further push up government debt. A detailed and credible fiscal consolidation plan, including both revenue increases and spending cuts, is therefore essential to maintain confidence in Japan’s fiscal situation. A top priority is to implement the government’s proposal to hike the consumption tax rate beginning in 2014, if not before. The Bank of Japan should maintain its virtually zero interest rate policy and continue active quantitative measures until inflation is firmly positive at the target rate of around 1%.