Japan’s Economy Slips Into Recession and to No. 4 in Global Ranking

The Japanese economy contracted at the end of last year, defying expectations for modest growth and pushing the country into a recession.

Japan’s unexpectedly weak economy in the fourth quarter was the result of a slowdown in spending by businesses and consumers who are grappling with inflation at four-decade highs, a weak yen and climbing food prices.

The end of the year also marked a moment that had been expected: Japan’s economy, now slightly smaller than Germany’s, fell one notch to become the world’s fourth-largest economy.

On an annualized basis, gross domestic product fell 0.4 percent in October through December after a revised 3.3 percent decline in the previous three-month period. Economists had been forecasting fourth-quarter growth of around 1 percent.

The figures cloud the outlook for Japan’s economy. Corporate profits are at record highs, the stock market is surging and unemployment rates are low. But consumer spending and business investment — two key drivers for the economy — are lagging.

Shinichiro Kobayashi, principal economist at Mitsubishi UFJ Research and Consulting, said the economy is “polarized” because of higher prices. When corporate profits jump, the prices of goods also go up, but wages have not kept up and consumers are reluctant to spend, he said.

A big question will be if Japanese workers can score a meaningful increase in wages this year.

“The ball is the corporate sector’s court,” said Mr. Kobayashi.

The two straight quarters of negative growth means that the economy is technically in recession, but the figures are preliminary. A large enough revision higher could nullify the recession label.

The soft economic data also complicates an upcoming decision from the Bank of Japan about whether to move ahead with the country’s first interest rate hike since 2007.

Japan’s central bank has stubbornly maintained policies meant to keep interest rates low and to spur spending — a remnant of its long-running battle to combat deflation. Many economists had speculated that the central bank may finally change course as early as April if the economy seemed to be on stronger footing.

Marcel Thieliant, head of Asia Pacific at Capital Economics, wrote in a research note that he “doubts” the disappointing fourth-quarter figures will prevent the Bank of Japan from ending negative interest rates in April even though economic growth will remain “sluggish” this year.

One sticky issue for the central bank remains the persistently weak Japanese yen. The currency’s decreased purchasing power means the cost of goods imported to Japan goes up, adding to the inflationary pressure that consumers feel. However, it tends to help the bottom line of many leading Japanese firms that sell goods abroad and bring those foreign earnings back to the country in yen.

By holding steadfast in the last couple of years even as the European Central Bank and the Federal Reserve have raised rates, the Bank of Japan’s policies have added to the yen’s weakness. This has made it attractive for global investors to borrow yen at very low interest rates in Japan and then invest those funds in dollars or euros at much higher interest rates in the West.

Saisuke Sakai, senior economist at Mizuho Research & Technologies, said it seems likely that the domestic economy would contract again in the first three months of this year because of disruptions from the major earthquake in January that rocked western Japan — a region rich with manufacturing.

This could hurt consumer sentiment even more.

“If we have three straight quarters of negative growth, people would feel like ‘Is the Japanese economy really OK?’” Mr. Sakai said.

With the release of its year-end gross domestic product numbers, Japan also ceded its spot as the third-largest economy behind the United States and China, a position it has held since it was eclipsed by China in 2010. Germany now holds that distinction in terms of U.S. dollars, which are the principal currency used in global trade and finance.

In fact, the German economy is also sputtering. Its decision to stop buying cheap Russian natural gas and oil following the Russian invasion of Ukraine has driven energy costs up sharply, even as the country has shifted to suppliers in the Mideast, the United States and elsewhere.

Japan could in the coming years lose its hold on No. 4, as its shrinking population will struggle to keep up with the growth of India, the world’s most populous country.

Keith Bradsher contributed reporting.