TOKYO, May 16 ― Japan's economy contracted in the first quarter, squeezed by weaker consumption and external demand and throwing a fresh challenge to policymakers as the central bank looks to lift interest rates away from near-zero levels.

Preliminary gross domestic product (GDP) data from the Cabinet Office today showed Japan's economy shrank 2.0 per cent annualised in January-March from the prior quarter, faster than the 1.5 per cent drop seen in a Reuters poll of economists. Downwardly revised data showed GDP barely grew in the fourth quarter.

The reading translates into a quarterly contraction of 0.5 per cent, versus a 0.4 per cent decline expected by economists.

Private consumption, which accounts for more than half of the Japanese economy, fell 0.7 per cent, bigger than the forecast 0.2 per cent drop. It was the fourth straight quarter of decline, the longest streak since 2009.

"Japan's economy hit the bottom in the first quarter,” said Yoshimasa Maruyama, chief market economist at SMBC Nikko Securities. "The economy will certainly rebound this quarter thanks to rising wages although uncertainty remains on service consumption.”

Capital spending, a key driver of private demand, fell 0.8 per cent in the first quarter, versus an expected decline of 0.7 per cent, despite hefty corporate earnings.

External demand, or exports minus imports, knocked 0.3 of a percentage point off first quarter GDP estimates.

Policymakers are counting on rising wages and income tax cuts from June to help spur flagging consumption.

The drag to growth from an earthquake in the Noto area this year and the suspension of operations at Toyota's Daihatsu unit are also expected to fade.

Still, a sharp decline in the yen to levels unseen since 1990 has fuelled concerns about higher living costs, squeezing consumption.

The Bank of Japan (BoJ) raised interest rates in March for the first time since 2007, in a landmark shift away from negative rates, but the central bank is expected to go slow in unwinding easy money conditions given a fragile economy. ― Reuters