Japan has yet again returned to deflation just as Prime Minister Suga is handed the baton from Shinzo Abe. The news follows initial relief among investors that Suga has vowed to continue with his predecessor’s policies, removing some near-term uncertainty.
But the returning spectre of deflation serves as a stark reminder of the failure of Abenomics and the Bank of Japan (BoJ) to generate inflation.
Lower inflation can help support consumer spending by improving purchasing power. If prices are expected to fall, households would delay spending to take advantage of lower prices, only for demand and prices to slip further.
Genuine deflation – a broad persistent fall in prices - as opposed to being caused by one-off factors, would pose a risk to the economic recovery.
When we explore what has caused inflation to dip, our view is that it is too early to declare the return of genuine deflation in Japan but factors weighing on the outlook suggest the risk is high. With limited ammunition, this poses a challenge for the Bank of Japan.
What has driven inflation lower?
In August, Consumer Price Index (CPI) inflation fell to 0.2% year-on-year (y/y). The measure of inflation targeted by the Bank of Japan, CPI excluding volatile fresh food prices, fell to -0.4 y/y. Also excluding energy prices, prices are falling by 0.1% y/y.
Overall, our view has been that despite aggressive monetary stimulus, Covid-19 lockdowns are a deflationary shock for the world economy. But, looking into the details, what exactly is responsible for lower inflation?
Since January 2020, headline CPI inflation has fallen by 0.5 percentage points (pp). When we break this down, two factors stand out as the main drivers (table 1).
Firstly, the energy-related components; transport along with fuel, are responsible for 0.3pp of the fall. This reflects the drag on inflation from the lower oil price.
The second is the 0.45pp negative contribution to inflation from culture and recreation. Most of this reflects the recent 32% y/y fall in accommodation prices.
This is the impact of the government policy campaign “Go To Travel”. Starting in July, the government subsidises domestic travel in an attempt to boost local tourism.
Investors may breathe a sigh of relief that the recent dip into deflation has mainly been driven by external and temporary factors; the oil market is an international market and the accommodation subsidy will not last forever, falling out of inflation calculations in one year’s time.
However, a large share of the rest of the basket is also weighing on inflation, albeit very mildly. Within the main components of the inflation basket, food is the only area pushing up inflation.
Will deflation persist?
When taking a view on inflation going forward, we split the basket into its various components (Chart 2).
First up are prices in the economy related to energy, including transport, which accounts for 18%.
Second is food, which accounts for 26% - a relatively high share compared to other developed markets (Chart 3).
And last but definitely not least, core inflation, which is the rest of the inflation basket. This accounts for 55%.
Energy a drag for now
As countries locked down to halt the spread of the pandemic, concerns surrounding world demand led to the collapse of oil prices.
Oil prices have since recovered somewhat, but a combination of spare capacity and a second coronavirus wave have hampered the recovery. Oil prices remain below where they were a year earlier.
The implied future oil price from the forward curve today suggests a very mildly deflationary force on energy and transport (Charts 4 & 5).
However, from the second quarter of 2021, base effects then kick in, and energy and transport should add to inflation.
But, investors should be wary. Longer term, this is actually deflationary for the economy as higher oil prices reduce household purchasing power which reduces demand.
Food prices aren’t going to help
Moving onto food price inflation. Food has a relationship with previous global wholesale food prices once converted into yen (Chart 6), which means Japanese food inflation should provide a neutral to negative force on inflation.
This is important as food is included in the inflation measure targeted by the Bank of Japan as well as its measure of core inflation. Fresh food, only 4% of the whole inflation basket, is particularly volatile so is excluded (Chart 7).
Core inflation to trend lower
Onto everything else. Chart 8 and 9 shows CPI inflation excluding energy, transport and food. This is narrower than the BoJ’s definition of core inflation, which only excludes energy and fresh food.
But this measure is more comparable with other countries and the idea is the same.
Core inflation captures the underlying inflation trend in the economy and therefore has a long-run relationship with economic capacity. If the economy has excess capacity (or excess supply), inflation tends to fall.
If the economy has insufficient capacity or excess demand, inflation tends to rise. Although it is several areas of the economy lumped together, this is the most important part of inflation.
Along with other economies, Japan has suffered a deep recession as a result of measures imposed to contain the outbreak of Covid-19. Beyond the short-term release of pent-up demand, growth is unlikely to be strong enough to quickly use up the spare capacity caused by the downturn.
In July, the capacity utilisation rate stood at only 82% after falling to 71% in May. Measures of capacity in both capital and labour markets show a similar picture, indicating less inflationary pressure going forward.
As the June Tankan survey shows, production capacity is now in excess. The survey shows that firms are now no longer reporting significant labour shortages, though not excess capacity either.
This is consistent with the fall in the number of job openings to applicants, which still remains above one.
On the other hand, falling wages – albeit mainly driven by falling bonus and overtime - signals excess capacity in the labour market.
Other special factors
There are other one-off factors to consider.
Firstly, the impact of the “Go To Travel” accommodation subsidy should continue as the policy was extended to Tokyo from October.
Secondly, in October 2019, value-added-tax (VAT) was increased from 8% to 10%. Despite being mostly offset by a reduction in education fees, this was slightly inflationary.
Adjusting for this, CPI excluding fresh food is lower at -0.8% y/y (rather than -0.4% y/y). In October, this special factor will drop out of the annual comparison acting as a drag.
Finally, in the medium term, Prime Minister Suga has expressed his ambition to cut mobile phone charges given the oligopoly in the sector.
Wasting no time, he has already instructed the relevant minister to look into this. According to our calculations, a 10% cut in mobile phone charges would reduce headline inflation by 0.2pp (Table 2).
High risk of return to deflation poses a challenge for the BoJ
We find that it is too early to declare the return of genuine deflation in Japan as lower inflation has been driven mainly by external and special factors. The fall in the oil price and “Go To Travel” subsidy have driven Japanese inflation into negative territory.
But with these set to continue, inflation will likely fall further by the end of the year. Against a backdrop of ample spare capacity, the risk of returning to deflation is high.
Keeping inflation expectations from slipping will be crucial to stopping this and in turn, necessary for the Japanese recovery.
With limited ammunition left and concerns around financial stability, there is little the Bank of Japan can do.
An easy option is to strengthen its forward guidance but given this is a well-trodden path, it will probably have little impact.
Alternatively, the BoJ, through purchases of government bonds under yield curve control, could allow Japanese government bonds (JGB) yields to drift lower. This could also help to weaken the yen.
Even then, Japanese households will likely remain cautious, which keeps the recovery in global trade an important driver of the Japanese recovery.