Japan: the land that inflation forgot

Richard Jerram | Jul 28, 2008
Inflation in Japan has two features that make it unusual. First is that the headline rate is still within the target range of the central bank, even though that range is an unnecessarily – and inefficiently – ascetic 0-2%. The underlying rate – excluding food and energy – is flat even though the economy is experiencing its longest post-war expansion.

Second, and more controversially, is the argument that higher inflation can help the economy. This has been receiving most of the attention in recent weeks, but the first point should not be ignored.

When ending its quantitative easing policy in March 2006 the BOJ produced a new framework to act as the guide for monetary policy. One of the striking features of the framework was a belief that price stability in Japan was naturally lower than in other developed economies, defined by the BOJ as an inflation rate of 0-2%. This is where the ECB started out, although it has since recognised that a more efficient inflation rate is “close to, but below 2%”.

Apart from the basis of the argument, the BOJ’s framework was undermined by its claim that there was “no significant bias” in the measurement of CPI. A few months later a base year revision took around 0.5ppt off the measured rate. This took inflation back into negative territory, which was awkward for the BOJ, as it had undertaken not to tighten policy until inflation was positive and expected to remain so.. An NBER paper by Christian Broda and David Weinstein titled “Defining Price Stability in Japan: A View from America” calculates that if the US methodology were used, then the measured inflation rate in Japan would be almost 1% lower.

The BOJ uses a Phillips Curve approach as its basic guide to policy. This is implicit in the rhetoric of officials, as well as in the bi-annual economic forecasts, which focus on the question of whether growth is above or below trend. The justification for tightening has been that excess capacity has been eliminated, growth is above trend, policy is loose and so inflation will accelerate.

Coming out of over a decade of poor economic performance due to financial system and deflation there should be even less confidence than usual in any attempt to measure trend growth or the output gap, so this forms a poor basis for policy decisions. And so it has been, with GDP growth averaging 2.1% over the past five years, but underlying inflation remaining negative.

Japan stands alone in the developed world with underlying inflation still flat and headline inflation within the central bank’s target range (it was 1.4% in the April-June quarter). Efficient fuel use means that energy is only 7% of the CPI basket, while a complex import regime means that food prices have not risen significantly. These two items accounted for 1.1ppt and 0.9ppt of the 2.0% YoY inflation rate in June.

Underlying inflation should grind higher in coming months as a result of stronger wage growth. Headline inflation probably peaks in the July-September quarter, but wage inflation should help to prevent it from slowing too sharply.

So much for griping about the policy framework. The more intriguing claim is that inflation might help Japan. This sounds like one of those “Japan is different” arguments that we sometimes hear. For example the former Economy Minister (and prime ministerial hopeful) Kaoru Yosano recently joined those pushing for an increase in interest rates to help to boost growth.

In fact the argument about the positive effects of inflation is really an argument about real interest rates. Inflation due to rising commodity prices hurts Japan in the same way that it does other commodity-poor economies, through deteriorating terms of trade.

So far that damage has been partly offset by the commodity exporters spending some of their windfall gains on manufactured goods from the developed world, with Japan fortunate to have retained a relatively large industrial sector. As a result export volumes have been growing as fast in CY08 as they did in CY07, despite the obvious difficulties with demand from the US, which takes around 20% of Japan’s exports. Unfortunately, this looks unsustainable, as inflation is leading to policy tightening in various developing economies, which is likely to cut into Japan’s export growth.

It seems unlikely that commodity prices rises will lead to front-loading of spending decisions. Japanese consumers have shown themselves to be highly sensitive to small changes in prices, for example buying cars and housing in advance of the increase in the sales tax from 3% to 5% in 1997. However, food and energy purchases do not really lend themselves to be front-loaded, especially in a country where space is at such a premium.

The unique issue – and potential positive – for Japan comes from the unusual portfolio selection of households. Over half of all financial assets (which amount to three times GDP) are in the form of cash or bank deposits. While some cite this as an example of the conservative nature of Japanese savers – with the majority of funds managed by those over the age of 60 – in part it simply reflects the impact of sustained deflation. No other country has endured a similar experience with deflation, so it is unsurprising that the resulting portfolio choices are unusual.

Over a decade of deflation and falling real estate prices meant that the returns on cash in Japan were relatively attractive. Households are not wedding to this choice, and funds trickled out of the banks in 2005-06 when real interest rates on bank deposits turned negative and other assets looked more attractive.

Real interest rates are now clearly negative, and the perception is even worse. A recent BOJ survey showed that respondents thought prices had risen 10% over the previous year, and would rise a further 7% over the coming year. This should make people nervous in having such heavy weighting of risk free assets. So far it seems that fear over the impact of global financial crisis is a stronger factor than the need to seek better nominal income, but when markets stabilise, a flow out of the bank should resume.

At the margin the flow has already begun. I estimate that there is 4-5% of GDP being held in the form of bundles of cash held for savings (non-transaction) purposes
I calculate that this money is starting to come out from the mattress and into interest earning bank deposits, presumably in response to the perception of high inflation.

The game of asking where some of this Y775tr (US$7.2tr) of cash and deposits might be heading is entertaining, but probably not particularly useful. Some will be spent. Much will head for assets that are still low risk, but offer slightly better returns. Domestic equities, foreign assets and real estate all have their champions and with such large sums involved, even a small flow could potentially have a large impact.

The discussion can turn more fanciful, with some seeing the search for yield translating into pressure on corporate management to increase payout ratios, or to manage their business more efficiently in order to increase shareholder returns.

In my experience the revulsion to the basic “inflation is good” nostrum means that people are neglecting the potential impact from negative real interest rates on portfolio choices. This could be the source of a new era of carry trade at some point in the coming year.



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