• Japan's economy is showing signs of steady recovery, with business sentiment remaining stable.
• However, service-sector firms project a souring of business conditions due to weak global growth and volatile financial markets.
• Despite the yen's surge, big manufacturers' business sentiment remains unaffected, and companies plan to increase capital spending by 10.6% in the fiscal year to March 2025.
• The Bank of Japan's monetary policy will play a crucial role in shaping the future trajectory of the economy, with the central bank's actions in the coming months being critical in steering the economy towards a sustainable path of recovery.

The Japanese economy has been demonstrating signs of a steady recovery, as indicated by the business sentiment in the three months leading up to September. The Bank of Japan's tankan survey revealed that the headline index measuring big manufacturers' business confidence remained unchanged at +13, matching median market forecasts. This stability in business sentiment is a positive sign for the economy, suggesting that it is on track for a moderate recovery.

However, the outlook remains cautious, particularly for service-sector firms. These companies are projecting a souring of business conditions over the next three months, due to weak global growth and volatile financial markets. This cautious outlook is reflected in the sentiment index for big non-manufacturers, which rose slightly to +34 from +33 in June, exceeding market forecasts of +32.

Despite the yen's 11% surge in the third quarter, big manufacturers set their dollar/yen estimate for the current fiscal year at 144.96, up from 142.68 in the June survey. This indicates that the yen's rebound since mid-July has not significantly impacted big manufacturers' business sentiment.

Inflation Expectations and Monetary Policy

Companies are expecting to increase capital spending by 10.6% in the fiscal year to March 2025, which is smaller than a median forecast for an 11.9% gain and down from an 11.1% increase three months earlier. This suggests that while businesses are still planning to invest, they are doing so at a slower pace than previously expected.

Inflation expectations are also noteworthy. Companies expect inflation to stay above the BOJ's 2% target one, three and five years ahead, backing up the central bank's view that Japan is making progress towards durably achieving its price goal. This is a prerequisite for hiking still-low interest rates.

The BOJ ended negative interest rates in March and raised its short-term policy rate to 0.25% in July, reflecting its view that Japan was making steady progress towards durably achieving its 2% inflation target. BOJ Governor Kazuo Ueda has stated that the central bank will continue to raise rates if companies keep hiking prices and wages due to optimism over the outlook, and help keep inflation durably around its 2% target.

Cautious Outlook and Historical Similarities

However, the survey found Japanese companies remain cautious about the outlook. While big manufacturers expect conditions to improve three months ahead, non-manufacturers project conditions to worsen. This suggests that the momentum among non-manufacturers, including hotels and restaurants that had been boosted by inbound tourism, could have already faded.

The weak yen has given a boost to exports and retailers benefiting from a surge in inbound tourism. The recent rebound in the yen would hurt exports and inbound tourism, but ease the pain on retailers and households from rising import costs.

Japan's economy expanded by an annualized 2.9% rate in the second quarter as steady wage hikes underpinned consumer spending. Capital expenditure continues to grow, though soft demand in China and slowing U.S. growth cloud the outlook for the export-reliant country.