Japan's economy shrinks far more than expected in third quarter

Japan's economy shrank at its fastest annualized quarterly pace in two years in the July-September period, provisional government data showed Wednesday, as rising domestic inflation weighed on consumer demand, adding to export woes as demand waned.

Both declines were Japan's first in four quarters and are part of an unstable trend since the start of the Covid-19 pandemic in early 2020 that has seen periods of economic expansion alternating with contraction. The latest growth print underscores the policy challenges that Prime Minister Fumio Kishida and Bank of Japan Governor Kazuo Ueda face in the coming months.

Provisional gross domestic product fell 2.1% in the third quarter compared to a year ago, after expanding 4.8% in April-June. This was its biggest contraction since the third quarter of 2021 and a bigger contraction than the expected 0.6% decline in a Reuters poll. The GDP deflator in the third quarter stood at 5.1% on an annualized basis.

The world's third-largest economy also contracted 0.5% in the third quarter from the previous quarter, after expanding 1.2% in the second quarter from the first. This was also a larger contraction than expectations for 0.1% contraction.

"The biggest drag on activity came from stock building, which subtracted 0.3%-pts from GDP growth last quarter. Even so, it's worth noting that there was a concurrent, broad-based decline in private demand," said Marcel Thieliant, Capital Economics' head of Asia-Pacific coverage.

The weaker GDP print was partly driven by weaker than expected domestic capital expenditure, which contracted 0.6% in the third quarter from the second quarter — as opposed to expectations for a 0.3% expansion, according to the same government release.

Private consumption in Japan was flat in the third quarter from the previous quarter, as domestic and foreign demand weighed on the economy.

"With real household incomes set to fall at least until the middle of next year, that bodes ill for consumer spending, which we expect to grind to a standstill next year," Thieliant added.

The Japanese yen was trading at about 150.6 against the U.S. dollar in mid-morning trade Wednesday, coming off its lowest in a year while still languishing near its lowest in more than three decades.

The fragility of the Japanese economy underscores the complexities for its central bank as Ueda mulls the feasibility of its ultra-easy monetary policy.

It also bolsters the case for the Japanese government's 13.2 trillion yen ($87 billion) economic package aimed at curbing rising living costs. It's expected to feature subsidies and payouts to low-income households to mitigate soaring energy and utility bills.

— CNBC's Shreyashi Sanyal contributed to this story.