Why Abenomics' stimulus policies could be backlashing against Japan

Wages are still struggling to keep up.

The marked contraction in Japanese GDP in the second quarter was largely expected, and in line with Fitch Ratings' forecast for the economy to expand by 1.6% over the full year - above the consensus view.

According to a release from Fitch Ratings, risks and uncertainties remain despite the relatively favourable short-term growth outlook.

The "Third Arrow" structural reforms have yet to show that the growth rate will trend upward over the medium term; wage growth has failed to accelerate convincingly; and lasting fiscal consolidation is not yet assured.

The second quarter 6.8% (qoq annualised) GDP contraction, announced on 13 August, was the worst quarterly figure for the Japanese economy since 2011.

However, the decline was due principally to timing effects on consumption from the implementation of a 3ppt increase in the consumption tax on 1 April.

Here's more from Fitch Ratings:

The contraction was actually smaller than expected, with Bloomberg consensus forecasts calling for a 7% decline.

Furthermore, yoy growth for 1H14 came to 1.3%, owing to the strong growth in 1Q14.

Fitch's full-year growth forecast of 1.6% remains in place, with exports forecast to pick up in the second half.

Fitch continues to highlight that the outlook for the sovereign rating will depend on several key factors over the longer term.

These include whether structural reforms will be implemented in sufficient scale to raise the trend growth rate above the current 0.5%-1.0%, and whether government will continue to reduce the budget deficit within a credible framework for consolidation.

Thus far, the "Abenomics" fiscal and monetary stimulus policies have been sufficient to bring Japan out of deflation, but this is proving a double-edged sword as wages are not keeping up with prices.

The increase in the seasonally adjusted nominal wage index of 0.4% yoy in June was well below CPI inflation of 3.7%, resulting in a marked contraction in real wages.

More encouragingly, "core" inflation (excluding food and energy) is running at 2.4% yoy, which Fitch estimates is approximately 0.5-1.0% yoy if excluding the effects of the consumption tax hike.

However, households face actual inflation in the shops, not core inflation.

Sustained real wage contraction would risk tipping Japan back into sluggish growth around or below potential.

Downwards pressure on prices might then resume in such a scenario after the effects of the yen's depreciation since end-2012 work themselves through the system.

Fiscal consolidation remains another key issue where there are risks.

Fitch expects the government to announce by December whether it will proceed with its plan for a second hike of the consumption tax to 10% in October 2015 (from 8%).

The government has been vague over how it will decide whether to raise the tax or not, though it is likely that the outlook for consumption - and, by extension, the prospects for stronger real wage growth - will be key.

A further improvement in economic conditions - enabling the government to raise the consumption tax - would contribute to the case for a stabilisation of the sovereign rating.

By contrast, ongoing weakness in wages and consumption, preventing the economy from achieving higher rates of growth, would inhibit prospects for fiscal consolidation and be ratings negative.