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Pedestrians are silhouetted at a shopping district in Tokyo August 13, 2014. A sales tax hike last quarter drove Japan's conomy into its biggest contraction since the March 2011 earthquake and tsunami, Cabinet Office data showed on Wednesday, keeping policymakers under pressure to expand fiscal and monetary stimulus should recovery falter again.YUYA SHINO/Reuters

Japan's economy nosedived in the second quarter as consumer spending plunged in the wake of a stiff sales tax hike, raising fresh concerns about Abenomics and increasing the chances of further government stimulus measures to keep the stumbling recovery on track.

Abenomics – Prime Minister Shinzo Abe's mix of aggressive monetary and fiscal policies and structural reforms – is aimed at avoiding such sharp downswings, which sap confidence and raise the spectre of renewed deflation.

The world's No. 3 economy contracted 6.8 per cent on an annual basis as it completely reversed gears from a 6.1-per-cent increase in the first quarter. It was the steepest decline since the first quarter of 2011, when a devastating earthquake, tsunami and ensuing nuclear disaster in northeastern Japan wreaked havoc on the economy, chopping GDP by an annual 6.9 per cent.

The main culprit was a stunning 19.2-per-cent fall in household expenditures on an annual basis and a more moderate drop in business spending, neither of which should come as any surprise. It's merely the flip side of the first-quarter spending spree by consumers and businesses in advance of the hefty sales tax hike to 8 per cent from 5 per cent, which took effect April 1.

Neither the first-quarter binge nor the second-quarter retrenchment – which was actually slightly better than the consensus forecast – reflect the reality of an economy destined for a long, slow, grinding recovery.

The Bank of Japan is pegging growth this fiscal year at a mere 1 per cent, a level that may be unreachable in light of the dismal quarter, a continuing steep drop in industrial output, a surprising decline in machinery orders and a clouded export picture.

The question now is where the economy heads in the coming months and whether the government or central bank will step in if the direction isn't to their liking.

Although no worse than expected, the second-quarter numbers highlight "the challenge that the Bank of Japan and the government face in pushing the economy out of deflation," Benjamin Reitzes, senior economist with BMO Nesbitt Burns, said in a note. "The recent data have been on the softer side, and if that continues, we could see more easing from the BoJ and potentially more fiscal stimulus."

Economics Minister Akira Amari is keeping his options open. "At the moment, I don't feel the need [for extra stimulus]. But we will take necessary steps as appropriate, depending on economic developments from now on," he told reporters. "Appropriate steps mean every possible measure."

Most analysts remain mildly positive about Japan's outlook.

"Looking ahead, it is tempting to become pessimistic about the prospects for the second half of the year," economist Marcel Thieliant, who keeps tabs on Japan for Capital Economics, said in a note.

"However, it was always unlikely that the impact of the consumption tax hike would fade overnight. It is encouraging that consumer spending is already on the mend."

Mr. Thieliant also pointed to solid employment growth, a decline in spare capacity and the likely moderation of price pressures as positives for the economy. "The upshot is that we still expect the recovery to resume in coming months."

More pessimistic economy watchers note that, apart from the first-quarter spending binge, most corporations and individuals have not been putting much of their hefty savings to work and that a big chunk of Japan's growth over previous quarters can be traced to the hefty infusion of fiscal stimulus.

"Now that that seems to be petering out, the economy is very much sliding back to where it was when all of this [Abenomics] started out," said Noriko Hama, a professor at Doshisha University's Graduate School of Business in Kyoto and an outspoken critic of current government policies.

The economy has essentially split into hot and cold spots, Ms. Hama argues. And the latter "is actually quite a substantial part of the economy. Therefore, despite all the fun and games going on in the hot spot [where the major export-oriented companies reside], that cold spot will actually hold back the economy and will remain very stubbornly deflationary."

We'll know soon enough who is right, but it remains too tough to call this particular race.

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