Japan’s economy is likely to have contracted in the first three months of 2024 due in part to disruptions at car makers, clouding the growth outlook as the central bank attempts to set the right pace for policy normalization.

A government report on Thursday is forecast to show that gross domestic product (GDP) shrank at an annualized pace of 1.2% in the three months through March, according to economists surveyed by Bloomberg. The preliminary data is expected to show that spending by consumers and companies fell, while net exports exerted a drag on growth for the first time in a year.

"The result will likely show that Japan’s economy is at a standstill,” Yoshiki Shinke, a senior executive economist at Dai-Ichi Life Research Institute who has won forecasting awards, wrote in a note on May 10. "The main reason for the contraction is the significant reduction of auto production” after a verification certification scandal erupted at Daihatsu.

The production halt by Daihatsu, a subsidiary of Toyota, weighed on auto sales, exports and corporate capital investment, according to Shinke.

The GDP report comes as Japan’s economic policymaking reaches an inflection point. Gloomy economic conditions, especially weak consumption, raise questions over whether the Bank of Japan will be able to take further steps toward policy normalization following its historic interest rate hike in March.

The BOJ is paying close attention to whether demand-driven inflation, backed by strong wage growth, is taking root in Japan.

The GDP data, subject to ongoing seasonable adjustments, may revise fourth quarter 2023 data to show a contraction instead of a positive annualized reading of 0.4%, according to Shinke. If so, a first-quarter contraction would mark the third in a row.

Economists mostly expect the BOJ to remain on course for another rate hike. Many forecast an economic rebound in the quarter through June, as auto output recovers and the highest wage gains in three decades buoy consumer sentiment. Real wages, adjusted for inflation, are likely to turn positive later this year, reversing two full years of declines as of March. Also, many households are set to receive one-off tax cuts starting in June.

Still, there are downside risks. Subsidies to cap rising utility costs are set to end at the end of May, fueling higher costs of living. And the yen’s weakness may add to shoppers’ woes via higher import costs for energy and food.

"I expect that the Japanese economy will be recovering from the second quarter on the back of exports and corporate capital investments while it’s hard to hope for a strong rebound in consumption,” Ryutaro Kono, chief Japan economist at BNP Paribas, wrote in a note on May 1.

The yen has become a focal point as it threatens to revive cost-push inflation. BOJ Gov. Kazuo Ueda recently adjusted his language on the matter, alluding to the yen’s policy implications, after the currency’s recent sharp moves generated speculation that authorities intervened in the foreign exchange market to support it.

"For the Bank of Japan, the swings in GDP won’t change the bigger picture — we think it’s resolved to normalize its policy, with inflation showing staying power,” said Taro Kimura, economist at Bloomberg Economics.

In the past, economic downturns have led to major economic stimulus packages that were partly facilitated by the BOJ’s rock-bottom interest rates.

The BOJ raised interest rates for the first time since 2007 in March, and persistently high inflation may pave the way for another move. There are signs of a division among ruling Liberal Democratic Party members over whether the central bank should hike again or keep rates low to smooth financing.

Prime Minister Fumio Kishida, whose support level remains low due to voter anger over a political slush fund scandal, pledged in March to ensure workers see their income gains beat the pace of inflation this year. He was speaking after the nation’s largest umbrella group for unions won commitments from large companies to raise wages by more than 5% during this year’s negotiations.

The approval rating for Kishida’s Cabinet registered 24% in a NHK poll taken this month, up 1 percentage point from April. On April 28, the LDP lost a by-election Kishida had described in part as a judgment on his performance. The party will hold its next leadership vote in September.