(Bloomberg) -- Japan’s economy shrank in the first quarter as consumers and companies cut spending, extending a dismal performance that stretches back to last summer and complicates the picture for the central bank as it mulls the timing of its next interest rate hike.

Gross domestic product contracted at an annualized pace of 2% in the three months through March, the Cabinet Office said Thursday. Economists had forecast a contraction of 1.2%. Private consumption and capital spending both retreated, while net exports also dragged. 

The report showed that the economy has failed to grow since last spring, as updated figures for the last quarter of 2023 were revised to show the economy flatlining after slumping in the summer.

The result reflects the negative impact of a New Year’s Day earthquake northwest of Tokyo and disruptions to auto production and sales after a certification scandal blew up at Daihatsu Motor Co., a subsidiary of Toyota Motor Corp.

While those factors can be discounted as temporary, the continuing impact of the strongest inflation in generations is a more enduring problem. Household spending keeps falling as workers contending with persistent declines in real wages tighten their budgets. Personal consumption has now declined for four consecutive quarters, the longest stretch of retreats since the global financial crisis.

The weak results come with the Bank of Japan looking closely at data to determine when it should next raise interest rates after it conducted its first hike in 17 years in March.

“The BOJ can’t ignore these GDP numbers. This is not at all the kind of situation where they can raise interest rates again right away,” said Nobuyasu Atago, chief economist at Rakuten Securities Economic Research Institute. “I don’t think they can move in July. They will have to wait for second quarter GDP data to come out in August.”

Many economists expect the BOJ to move again later this year. They forecast an economic rebound in the quarter through June, as auto output recovers and the wage hikes lift consumer sentiment. Many families will also receive one-off tax cuts starting in June.

What Bloomberg Economics Says...

“Japan’s first-quarter GDP shrank more than the market expected due to one-off factors — and won’t dissuade the Bank of Japan from normalizing policy.”

— Taro Kimura, economist

For the full report, click here.

While the first-quarter data painted a gloomy picture for the economy, there were positive developments as well. The first quarter saw companies emerge from annual negotiations with unions pledging the largest wage hikes in three decades. The prospect of higher pay eventually boosting consumption was a factor behind the BOJ’s decision to raise interest rates in March.

It remains to be seen if consumer spending will pick up strongly. Subsidies to cap rising utilities costs are set to end at the end of May, and the yen’s weakness is weighing on sentiment across a wide range of service industries.

“Rising prices, especially for daily necessities, have cooled consumer sentiment,” said Hiroshi Miyazaki, senior research fellow at Itochu Research Institute. “In terms of consumption trend going forward, I’m expecting rising wages and higher prices to push against each other.”

Japanese authorities and business executives have voiced concerns over the currency’s weakness, which has put pressure on households and small companies by inflating costs for imported energy and other materials even as exporters including Toyota post robust results.

The BOJ currently expects cost-push inflation to continue to ease and transition into demand-driven price rises. Governor Kazuo Ueda said the central bank would consider taking action if foreign exchange moves have a big impact on the inflation trend.

Recent sharp moves in the yen after it slid to a fresh 34-year low against the dollar suggest that finance ministry authorities intervened in the foreign exchange market to support it. Flows out of the BOJ’s accounts point to two likely interventions worth around ¥9.4 trillion ($60.8 billion).

A revision to the first quarter GDP figures is due on June 10, four days before the BOJ’s next policy decision, as speculation grows that the central bank may raise interest rates again in the coming months with the weak yen among the factors favoring an early move.

The central bank meets again in July and is due to update its price and growth forecasts then, before authorities get a glimpse at preliminary GDP statistics for the second quarter on Aug. 15.

In addition to its direct impact on shoppers and businesses, the weak yen has created a symbolic setback for Japan and its embattled leader Prime Minister Fumio Kishida by diminishing the size of Japan’s economy in dollar terms.

Germany surpassed Japan last year as the world’s third largest economy. The International Monetary Fund’s April projections now show Japan falling to fifth behind India in 2025, a year earlier than the Fund predicted in October.

Kishida has sought to change the narrative for Japan’s economy, declaring the nation on the verge of reaching a turning point in which it will usher in a period of new capitalism. At the same time, the premier has stopped short of declaring a definitive end to the deflationary rut that eroded the value of the economy for years after the nation’s asset-price bubble collapsed around 1990. 

In March, Kishida said preventing deflation from recurring is the purpose of his administration’s existence. He pledged to ensure that workers see their income gains beat the pace of inflation this year.

Kishida’s approval ratings have been abysmal against the backdrop of a political slush fund scandal and consumers’ simmering frustration over rising costs of living. His cabinet’s approval rating stood at 24% in a NHK poll taken this month, up 1 percentage point from April. 

On April 28, the LDP lost a special election Kishida had characterized in part as a judgment on his performance. The party will hold its next leadership vote in September.

(Adds economist’s comments)

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