Japan's Economy Shrinks In Q2 From Higher Sales Tax Effect, Stokes Deflation Fears

Japan’s economy shrank at a rate of 6.8 percent in the quarter ended June 30, compared to the same quarter last year. This is its biggest contraction since the 2011 earthquake and tsunami, according to media reports published Tuesday.

Caused largely by a sharp hike in the consumption tax, or sales tax, in April, Japan’s domestic private consumption, which constitutes 60 percent of its economic activity, fell by 5 percent against the previous quarter, BBC reported Wednesday. A drop in economic output was expected after the nation's consumption tax was increased in April to 8 percent from 5 percent. According to economists polled by Reuters, the country's economy was expected to shrink by 7.1 percent in the quarter as a result of the tax hike.

This was the first time Japan raised the consumption tax in 17 years and is an attempt by the Shinzo Abe-led government to rein in public debt by increasing government revenue. However, the steep fall in growth compared to the previous quarter -- when the economy grew at an annualized rate of 6.1 percent -- took some economists by surprise.

Yasunari Ueno, chief market economist at Japan-based Mizuho Securities, told The Wall Street Journal that the country’s economy could remain sluggish for longer than expected.

"The next focal point is how much the economy will rebound in the July-September period. If the upward pressure is weak, it will likely increase the chance that Prime Minister Abe decides in December to delay the next sales-tax hike," Ueno said.

Abe had earlier said that he would raise the consumption tax further to 10 percent in October 2015.

However, Akira Amari, Japan’s minister of state for economic and fiscal policy, reportedly expressed confidence that the economy would pick up later in the year.

"Japan's economy continues to recover moderately as a trend and the effect of the sales tax hike is subsiding," he said.

In a statement released last week, the Bank of Japan had announced that it would keep its monetary policy unchanged, and would continue to increase the country’s monetary base by 70 trillion yen, or $687 billion, annually, underscoring the central bank's conviction that no fresh near-term stimulus was needed to shake off the effects of a consumption tax hike.