Japan's reflation: New era or mirage?
With prices rising in Japan and signs of inflation becoming more domestically engrained, we ask has Japan truly escaped the deflationary trap? And what does this mean for the Bank of Japan?
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Japan's economic landscape is undergoing a transformation, emerging from a long period of deflation. From a core CPI (Consumer Price Index - which measures the change in the price of a basket of goods and services excluding fresh food) of -1% in December 2020, the annual inflation rate has reached 2.3% in December 2023, with the pandemic's disruption of supply chains playing a role, as has the weak yen. Now, with more people employed, inflation is becoming more domestically engrained. This is being boosted by the Bank of Japan’s (BoJ) ongoing ultra-easy monetary policy and government spending, as well as reforms on things like parental support, defence, green initiatives, and the labour market.
CHART1 Source: Schroders / Macrobond
While it appears that the BoJ has successfully escaped the deflationary trap, the question remains: are we witnessing the dawn of a reflationary era?
There are a few key signposts the BoJ is monitoring to determine whether inflation is here to stay:
- Wages (outcome of Shunto wage negotiations):
Shunto, is an annual event typically in Spring where labour unions negotiate with employers for wage increases and improved working conditions. 2023 saw 4.4% demanded with 3.6% achieved. This year the unions have guided they will be demanding 5% or more. The expected final outcome (Average Japanese Trade Union Confederation, or Rengo, Pay) is projected to be 3.66%.
CHART2 Source: Schroders / Macrobond
2. Broadening out of inflation (especially services which has historically been sticky around 0%)
One of the reasons Japan has suffered from deflation historically is due to companies not passing on input cost increases to consumers. It does generally take a long time to shift mentality, but there are signs of a shift towards broader price increases.
3. Inflation expectations re-anchoring higher
Inflation expectations have increased over the past two years, particularly for companies. Price expectations for households have risen too but are still some way off the BoJ's 2% target.
4. Growth prospects
The BoJ estimate of output gap (capital input gap + labour input gap) indicates the economy is just below potential. However, the Tankan factor utilisation index* suggests there is room for further growth.
CHART3 Source: Schroders / Macrobond
Q4 2023 GDP data showed an annualised 0.4% expansion, reversing the initial contraction in the estimate figures. Nevertheless, with private consumption falling for three consecutive quarters, sustainable inflation will be a challenge without robust growth.
So putting this together, what does it mean for monetary policy in Japan?
As a conservative central bank, the burden of proof is high for BoJ to make any changes to monetary policy. Our base case predicts the removal of the negative interest rate policy in either their 19 March or 26 April meeting. There onwards they will need firm inflation & growth to warrant a continued hiking cycle, nevertheless given their caution stance, any hiking cycle will likely be gradual.
* The Tankan factor utilisation index is a key economic indicator in Japan, published by the Bank of Japan. It's part of the Tankan survey, which is a comprehensive business sentiment survey conducted quarterly among Japanese companies. The survey covers a wide range of topics, including business conditions, financial situation, capital expenditure plans, and employment conditions. The factor utilisation index specifically measures the degree to which companies are utilising their production capacity. It can provide insights into the current state of the economy. For instance, a high factor utilisation index might indicate strong demand and potential inflationary pressures, while a low index could suggest weak demand and spare capacity in the economy.
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