(Bloomberg) -- Japan’s economy shrank at the sharpest pace since the height of the pandemic, an outcome that complicates the policy path for the Bank of Japan amid soaring speculation it is edging closer to scrapping the world’s last negative rate regime.

Gross domestic product contracted at an annualized pace of 2.9% in the three months through September from the previous quarter as households reined in spending, revised figures from the Cabinet Office showed Friday. 

The updated figure marked the deepest drop since spring 2020 and compared with a preliminary reading of -2.1% and consensus estimates of a slightly narrower contraction. 

The revised results confirm that Japan’s economic recovery from the pandemic lost momentum during the summer, with the outlook also shaky as overseas economies slow and sticky inflation continues to weigh on domestic consumption. 

Separate monthly data indicated more weakness in the current quarter, with household spending falling 2.5% in October from a year earlier, an eighth straight drop. Nominal wages gains of 1.5% in the month still left pay gains well short of the inflation that is weighing on consumer spending.

Taken together, Friday’s figures complicate the calculus for the central bank as authorities wait for more evidence that a positive wage-price cycle is in place before stepping back from a massive stimulus experiment of more than a decade. 

They also offer little respite for Prime Minister Fumio Kishida as he battles record low poll ratings amid criticism over a fund-raising scandal and his measures to tackle the impact of inflation.

“The revised data and the spending report show signs of weakness for consumption,” said Nobuyasu Atago, chief economist at Rakuten Securities Economic Research Institute. “It’s risky for the BOJ to end the negative interest-rate policy when the economy is already getting worse.”

“Still, I think their main scenario is they will make the move in January with new price forecasts,” Atago said, referring to quarterly projections that are sometimes used to justify policy adjustments.

The weak GDP readings come amid surging speculation in markets that the BOJ will move early to scrap its negative interest rate. Market chatter has been fueled by remarks from central bank chief Kazuo Ueda that his job will get more challenging from the end of this year and comments from his deputy apparently playing down the impact of a possible rate hike.

Japanese bond yields surged by the most in a year on Thursday and the yen strengthened almost 4% against the dollar. 

The Japanese currency gained further ground Friday after the GDP result, suggesting that the poor outcome hasn’t stemmed the tide of speculation that the BOJ may act as soon as its December meeting rather than wait for fourth quarter GDP figures in February and annual wage negotiation data in March.

Almost all economists surveyed by Bloomberg before Thursday’s surge in the yen expect no change in policy from the BOJ when it concludes its next meeting on Dec. 19. Two-thirds of them see the bank scrapping its negative rate early next year. April is seen as the the most likely timing, with a risk of an earlier move in January.

What Bloomberg Economics Says...

“The deeper contraction doesn’t inspire confidence in the market view that the BOJ is getting closer to scrapping its yield-curve control policy.”

— Taro Kimura, economist

For the full report, click here.

The GDP data showed that consumption continued to slide over the summer with a 0.2% non-annualized fall compared with an initial flat reading. Capital spending numbers were bumped up, but still showed a 0.4% drop on quarter. Trade also weighed on growth.

A sharper fall in private-sector inventories shaved another 0.5 percentage point from growth, though a running down of companies’ stockpiled goods can also be seen as a positive sign for the economy going forward.

Still, the worse-than-expected consumer spending is a further sign that elevated prices are weighing on households.

The grinding impact of inflation on consumption carries a political cost for Kishida. Support for his administration has languished despite his latest economic stimulus package meant to help households cope with the rising cost of living. 

In addition to criticism of his party’s fundraising methods, if wage growth fails to keep up with soaring prices, causing more consumer pain, Kishida could face opposition when his Liberal Democratic Party next holds a leadership election in 2024.

Kishida met BOJ chief Ueda on Thursday to discuss monetary policy and the state of the economy. Kishida didn’t make any particular requests, Ueda said.

(Adds economist comments, more details from report)

©2023 Bloomberg L.P.