How much spare capacity is left?

Recent revisions to the GDP data suggest that the output gap has all but closed. However, the main factor holding back inflation over the last two decades were entrenched deflation expectations rather than a lack of demand. Unfortunately, the Bank of Japan has had no success in dispelling the “deflationary mindset” among households and firms. The upshot is that, while further loosening is off the table for now, any talk of policy tightening by the Bank of Japan is likely to prove premature. A key element of the Bank of Japan’s strategy to generate inflation has been to use aggressive monetary easing to boost demand and reduce spare capacity. Revised GDP figures released last month show that the Bank has had more success in boosting demand than previously thought. While the previous data implied that output only returned to the level prevailing ahead of 2014’s sales tax hike in the third quarter of last year, the new figures reveal that it took just one year for output to bounce back. GDP is now 1% higher than it was in Q1 2014.