No signs of Inflation in Japan

by Claus Vistesen

In this note, I will adopt a two-pronged approach. Firstly, I will do a round-up of the domestic scene in Japan and more specifically the inflation outlook as well as the subsequent outlook for a possible interest rate hike by the BOJ come February or March. Secondly, I will take a look at the international perspective on Japan, where there has been a recent flurry of news items on the Japanese economy, where especially the low Yen and the carry trades are very hot topics.

In(de)flation Moving Forward?

The Japanese economy simply does not seem to be able to catch a break these days. Back at the beginning of this month the BOJ had to dissapoint financial markets yet again as the central bank failed to find room for an interest rate hike. The reason for this is not slow growth per se but more specifically the persistent sluggishness in consumer spending figures which mirrors a domestic economy where demand seems locked in towards a steady decline despite a very low nominal interest rate of 0.25%. This also materializes itself in inflation figures which can be seen in a broad as well as a narrow perspective. In terms of the former, Japan has been fighting deflation for over 5 years now with annual inflation rates in deflationary territory (2002-2005) or very close to it. In 2006 the Economist Intelligence Unit estimated consumer inflation as running at 0.3%. Looking at the latter, where are we headed as we enter 2007 then? Sadly for Japan it now seems likely that deflation is steadily becoming a once more a reality rather than a pessimistic outlook. The first aspect of this is the growth in household spending which on a y-o-y basis in 2006 probably will come in very close to stagnation or even perhaps enter negative territory. The recent retail sales figures from December bode ill for the general bullish perspective on Q4 2006 and consequently for the prospects of a BOJ raise. On a monthly basis retail revenues fell 0.2% seasonally adjusted but more importantly sales on a y-o-y basis fell 0.3% which according to Bloomberg constitutes the biggest decline in the last eight months. Retail sales are of course here used as a proxy for household spending and I am beginning to wonder whether in fact the expected increase in consumer spending in Q4 2006 will in fact not be a dissapointment. Remeber also here that the second aspect of the decline in inflation going into 2007 is the recent dip in headline inflation as a function of dropping oil prices. As Artim pointed out recently the general outlook on oil prices still points to structural forces which will tend to push up prices but for reasons explained by Artim the headline inflation rate has been dropping throughout Q4 2006 and is set to continue into 2007. This of course only acts as another hit on Japan's already depressed inflation rate which incorporates the headline account in the overall inflation measure. Looking at what this means for inflation rates in Japan and subsequently the BOJ's ability to raise in February Takehiro Sato from Morgan Stanley estimates, for example, that the CPI index will go into negative territory as early as February-March on the back of a faster than expected decline in oil prices.

However, what about the tightening labour market and the prospects of wage-push inflation as the unemployment rate keeps on drifting down, from the current level of around 4%? To scrutinize this Edward had an illuminating post over at Bonobo Land which quotes a recent article from the FT. The FT article highlights some important points on the Japanese labour market which, based on the commentary by Hiroshi Shiraishi, economist at Lehman Brothers, directs us towards an explanation for the absence of wage push inflation in Japan. The first point relates to the global phenomenon of how corporate attention increasingly is biased towards shareholders which results in the increasingly missing link between booming corporate profits and wages. This is also reflected in the global labour arbitrage argument.

The second point relates to the compostional change in the labour force as large cohorts of highly paid baby-boomers are retiring and being replaced by much thinner young cohorts, who are obviously much lower paid. Also, the labour market reforms now mean that the seniority element in wages is now much less evident, and especially in the lower skill groups. The sum total of all this is to put an inbuilt and systematic downward pressure on wages.

Thirdly, and finally, Shiraishi points to the weak yen and how this is squeezing domestic companies' foreign buying power and especially inhibiting small companies from raising wages. However, despite these strutural economic aspects another data point caught my eye in the form of the jobs-to-job seeker ration which is at 1,08 to 1,00 and marks the tightest condition since 1992 according to the FT article. So it seems that although jobs indeed are present in the economy the supply side is having trouble following the demand side which I might add is pretty strong circumstantial evidence that at least a part of the labour market tightening process in Japan is due to the sustainened process of ageing and thus compositional change of the population structure and labour force.

In conclusion, what we have here then is hardly promising signs for Japan in terms of the domestic economy's ability to produce signs which would reinforce the BOJ's willingness to justify domestically a raise in the interest rate come February or March.

A Tough Burden to Carry?

A related topic to the one discussed above about how persistingly low figuers for consumer spending and thus inflation holds off the BOJ from raising is the issue of the low Yen and subsequent the Yen carry trade which exploits the interest rate spread between low yielding Japanese government debt and high yielding debt instruments (e.g. US treasuries). The first lesson here is that the transmission mechanism is very direct between economic data and the Yen because it all relates to whether investors expect the BOJ to raise or not. Consequently, Bloomberg (linked above) reports that the Yen recently fell to a fourth year low against the Dollar on the back of the dissapointing retail sales figures cited above. More importantly, the carry trade flows and outlook seem increasingly fortified as investors continue to bet short on the Yen at the same time as expectations point to both the Fed and ECB being likely to widen the interest rate spread thus making the carry trade even more profitable. In essence the carry trade follows a perfectly rational investor approach albeit with the subtle point that it basically hinges on low volatility and thus the expectation that the high-rated currency in the carry trade will not devalue. At a later point I will go into more detail here at GEM as to what drives the carry trade. Meanwhile, the carry trade is still the source of much debate and concern in Europe and the US, a debate which translates into a concern about an unhealthy build-up of leverage. Essentially, the concern boils down to the way in which a growing number of leading European politicians and economists are voicing their dissatisfaction with what they call the undervalued Yen relative to the Euro, and thus have started to protest about the inability of the BOJ to respond to what they perceive as being the sound fundamentals of the Japanese economy and thus raise rates to unwind the carry-trade, and even more importantly in a more general global perspective to contribute to the perceived need to mopup excess global liquidity. The criticism of Japan and concern over the carry trade and excess liquidity is for example becoming operationalized in the forthcoming G7 forum. So as we gear up for the G7 meeting next week we can be sure that especially European representatives will voice their concern over the distorting nature of Japanese monetary policy. However, what does this mean? To what extent will and indeed should investors correct to the messages from G7 and more importantly will the signals transmitted by the high lords at G7 really have an impact on the Yen?

In a recent research note, Robert Alan Feldman from Morgan Stanley points to the warranty of due attention to the signals coming from G7. It is of course always good to listen, but what should not escape our attention in this case is that this would not be the first time the G7(8) forum had tried to talk up the Yen. In fact they even tried to do this as recently as last September,and at that point all the talk ended up being cheap. In fact, I am going to pick a whee bit on Feldman here since he himself, only a few days ago, suggested that investor corrected to the fundamentals of the Japanese economy instead of the rhetorics of the BOJ and the Japanese policy makers. Surely this goes for G7 rhetorics as well, or what?

Japan Consumption Falls as Output Accelerates

Here's the latest bit of news from Japan:

Japan's factory production rose to a record, while household spending fell, underscoring the central bank's concern that growth has bypassed consumers and left the economy dependent on exports to expand.

Industrial production climbed a seasonally adjusted 0.7 percent in December, the trade ministry said in Tokyo today. Household spending declined for a 12th month, falling 1.9 percent from a year earlier, the statistics bureau said.

Without a recovery in consumer spending, Bank of Japan Governor Toshihiko Fukui may delay raising the benchmark overnight lending rate from 0.25 percent, the lowest among major economies. Wages grew 0.1 percent in the third quarter of 2006, when average corporate profits surged 15.5 percent.



This a really only serves to confirm the picture Claus has been arguing. I suppose it would be rather strong language to state that the entire consensus view was almost "out to lunch" on what was actually happening in the real world these days. Something important is happening in Japan, the sign of things to come (and lets just wait till we get round to some real data for Germany for January 2007), while at the other end of the scale people seem to totally underestimate India's growth potential, and the issue is one and the same in each case: demographics. On the one hand what we are seeing is a demographic penalty, and on the other a demographic dividend. Of course, in order to appreciate that this is the case you need to at least consider the possibility - contrary to classic textbook wisdom - that demography may be an important part of the macro growth picture.

Japanese Labour Market Conditions

Following on from my last post about the continuing Japanese consumption decline, I have put a somewhat larger post up on Afoe, trying to link this in with the latest figures for declining retail sales in Germany.

This piece from the FT which in general simply confirms the overall picture, does contain a useful perspective on how the dynamics of intergenerational transition may be also affecting the non pass-through of improved employment into spending:

Hiroshi Shiraishi, economist at Lehman Brothers, said he expected the divergence between strong corporate health and weak wages and consumption to persist.

Companies were taking a bigger share of profits worldwide, he said, but the trend was particularly stark in Japan where the component of more demanding foreign shareholders had increased sharply in the 1990s. “Corporations are increasingly more focused on the shareholder,” he said. “Especially at big companies, the workers’ share of corporate earnings is dropping very sharply.”

Second, said Mr Shiraishi, high-paid babyboomers born after the war were beginning to retire in large numbers and were being replaced by much lower-paid graduates. That trend would continue for several years, suppressing wages, he said.

Finally, the weak yen, though good for exporters, was squeezing profit margins of companies that needed to buy commodity inputs from abroad. “Small companies in particular are finding it difficult to pass on these costs by way of higher prices, so this is forcing them to restrain wages.”

Although the headline number for December edged up 0.1 per cent to 4.1 per cent, the more significant jobs to jobs-seekers ratio climbed to 1.08, the tightest labour conditions since 1992. That means there are now 108 jobs for every 100 people seeking work.

Japan's Economy: Chasing Illusions?

(Cross-post from Global Economy Matters)

What happened in Japan this week obviously came as something of a surprise for many a financial commentator and analyst; over at Morgan Stanley's GEF Takehiro Sato even felt the need to apologize to GEF's readers for erroneously making the call that the BOJ would raise interest rates this month. He has not been alone in this, however, and last Monday Bloomberg reported that 76% of investors were expecting the BOJ to raise come Thursday. This feeling had been reinforced by strong incoming data earlier in the week on machinery orders but alas, even as we reached Wednesday and the BOJ began its two day policy meeting local Japanese media were releasing insider information that the BOJ might actually have to hold rates steady one more time, and then yesterday, as yields on ten-year government bonds plunged accordingly, the leak was confirmed by the official BOJ decision to hold steady for yet another round effectively invoking the continuing weakness of Japanese consumer spending and the extremely low inflation reading. So what on earth is happening here?

One of the underlying discourses has of course become that of the BOJ's independence from the politicians and consequently many see the recent decision by the BOJ as evidence of a clash between the central bank and domestic political interests , a clash where the BOJ has been almost bullied into holding off raising rates despite general market expectations which have persistently and almost stubbornly pointed to the desireability of the opposite course, most notably given the perceived need to unwind the yen carry-trade. Now it is not that I don't think the political situation is unimportant, and clearly given the BOJ's relatively short stint as an officially independent institution old habits, it seems, still linger. However, I also think this is a question of the proverbial chicken and the egg since the real question here is whether in fact, given the economic situation in Japan, a raise would have been prudent? It should also not be forgotten that decision making in Japan is now extremely constrained, and what is often interpreted as undue political influence may well in part be a debate about where to move first, on interest rates or on the fiscal deficit, since as is well known (and as Edward cogently argues here) Japan - as the country with the largest debt to GDP reading on the planet - also need to do something to address the government debt issue, and there is a real difficulty presented , given the underlying weaknesses in Japan, by trying to move forward on both fronts simultaneously. In the following I will argue that given the past and future trend of consumer spending and inflation in Japan I do not see the foundation materializing for a rate hike let alone a process of interest rate normalization in Japan.

In order to frame my argument it is usefull to look at the recent history of Japanese monetary policy and economic growth. If we begin by the former Japan's monetary policy has since 1998 been characterized by a policy of zero interest rates (ZIRP) and quantitative easing (QE) set in place to combat deflation. The chart below shows the evolution of headline and core inflation in Japan between 2002 and 2006.

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The policy of ZIRP was temporarily (and briefly) terminated between August 2000 and March 2001 (so there is some precedent for the present situation) and now one more time the BOJ is trying to break out of the vice and is currently running an interest rate of 0.25% on the back of the ending of ZIRP which was officially initiated in June 2006. Already here, history should teach us something since we might very all ask ourselves whether or not the current stint above 0% interest rates will be temporary as well? So far the signs have been pretty clear in my opinion and it is actually very telling to look back to June 2006 when the BOJ's decision to take Japan out of ZIRP was hailed by many prominent economic commentators as the signal that Japan finally had escaped the claws of deflation and was on its track to join the leaders of the global economy. Yet, 9 months later the party just keeps on getting postponed it seems and in my opinion the continuing surprise amongst economic commentators on Japan's economy relates to the inability or reluctance to factor in one of the biggest structural drivers of the Japanese economy.

It's the Demographics Stupid

I will not go into a detailed description of Japan's demography in this entry but merely highlight the important factors. In short, Japan is the oldest society on earth with a median age of 42.9 years. This process ageing is driven by two factors; firstly increasing life expectancy where the average Japenese can expect to live a respectable 81.3 years and and secondly by a decline in fertility where Japan is hovering at around a TFR of 1.3. The crucial point here is then what in fact happens to an economy which experiences a process of sustained ageing like has been having in Japan in the latter part of the 20th century? I am moving the perspective up here but I do not think it is wholly unreasonable to link Japan's gradual transition in the 1990s into a growth path characterized by very low inflation rates and, as the chart below shows, a steady decline in consumer spending relative to GDP, to the sustained change in the population structure. The point is that as a population ages consumer spending declines relative to GDP based on the economic theory life-cycle behavior. There are of course bound to be notable differences between countries in terms of the effect of this but since the process of ageing at this point across OECD only seems to be accelerating we should expect the life cycle component to gain more weight.

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What Drives Economic Growth in Japan?

At this point, you would perhaps be tempted to claim that I, against my own assertion, am falling victim to the application of a monocausal explanation for an, after all, pretty complex problem situation. Obviously demographics are not destiny, but by applying demographics as an anchor for the economic analysis of Japan I sincerely believe we can take one step closer to the proper understanding of what is going on. The most important point here is the notion of the growth path and what in fact drives economic growth in Japan. Looking at the above chart which plots consumer spending in Japan as a share of GDP from 1995 to 2005 we can see that the overall trend is one of secular decline. However, if we look at economic growth in terms of real GDP in Japan in the recent years the numbers actually do not look that bad. As such, the period from 2001 to 2006 reveals an impressive transition from a meager 0.1% growth in real GDP in 2001 to an estimated rate of 2.7% in 2006 with growth running above 2% in both 2004 and 2005. In fact, this impressive growth stint coupled with two very strong first quarters in 2006 were a big part of what prompted the BOJ to end ZIRP in June last year. Yet, although 2006 in terms of GDP growth indeed shows a strong performance Japanese inflation is still creeping along very near the bottom and close to the 0% mark while household spending on a y-o-y basis is in negative territory as shown by the graph below.

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So where is the growth in Japan coming from? A notable indication here comes from the Q3 growth figures where GDP expanded 0.8% primarily on the back of export growth and corporate spending (investment) in factories and equipment, an analysis which is supported by the fact that consumer spending actually declined during the same period. This state of affairs is also mirrored in the continuing widening of the trade surplus and exports, for example, grew at the notable clip of 12.1% y-o-y in November 2006. I believe this detail to be very important especially in the light of how economic data and news sometimes tend to be interpreted. A notable case in point was the data for machinery orders released on Monday of this week, and which was immediately linked to the perceived need for the BOJ to raise. Moreover, we have also on several occasions heard how momentum in the buoyant corporate sector, as epitomized by investments in equipments and factories, has been narrated as a strong foundation on which the BOJ should soon raise. Yet, why is this evident? Clearly, the figures on consumer spending suggests that all these investments and machinery orders are not driven by domestic capacity components. This also allows me to debunk one of the most common Japan fallacies of the moment which concerns how the momentum in the corporate sector will automatically spill over into the domestic economy. Given the trajectory of Japan's demographic evolution we should perhaps not expect any notable transmission mechanism to be at work here. Another area where we might also wish to correct our views is in terms of the labour market which has been very tight throughout 2006, with an unemployment rate of about 4% going into 2007. Once again most commentators have connected the dots throughout 2006 in order to argue that the tightening of the labour market was a clear sign the that the recovery was on track and that notable momentum was present in the domestic economy. However, with a rapidly ageing population and thus declining labour force we might want to ask what in fact the structural component is in this 4% figure which indeed appears on the one hand to be a sign of such a tight labour market but on the other has not done much in terms of, for example, promoting wage-push inflation? Global labour arbitrage is an argument which is often advanced here, but may there not, actually, be other and deeper structural factors at work?

A Future Growth Path For Japan?

Given my analysis it is clear that one of the most important deductions to be made here is that an economy such as the Japanese with a rapidly ageing population will structurally tend to be driven by a growth path where domestic supply continuously exceeds domestic demand and thus the economy relies on exports to grow. Another way of putting this would be to invoke high capex (investments) as the main driver of growth but since this high capex is not met by domestic demand (capacity) the economy, as a function, of its demographics will run a surplus on the external balances. In fact, I am not the only Japan observer to be arguing this and in fact Morgan Stanley's own Robert Alan Feldman came damn close to a more adequate conceptualization of the whole situation a while ago back when he asked the tantalising question: What's 'funny' about Consumption in Japan? In essence, Feldman argues, as I do, that Japan in order to grow and as a function of its ageing population will need to continuously raise capex and productivity in order to compensate for lower consumption which again means that growth to greater and greater extent will be driven by its need and ability to export.

Now, dear reader, the plot indeed thickens even more does it not, since what Feldman (perhaps) does not realize is that by arguing that Japan with an ageing population will revert to a growth path driven by the need to leverage excess supply outside its borders is walking right smack into the discourse about demographics and global macroeconomic imbalances. The point is as simple as it is intriguing. It is consequently all well and good to argue that Japan needs to export as its population ages but what about Germany and Italy; will they not need to continually run trade surpluses as well. This is not to mention the behemoth China whose population is at some point also transisting into a rapid process of ageing as a function of its one-child policy. In fact, it does seem as if poor America (and perhaps places like the UK, Australia etc) is almost the only economy out there which is really able to run a respectable deficit and suddenly dear reader we are right back where I started a couple of days ago with the structural drivers of global macroeconomic imbalances and as such Japan will provide an important test case for our hypothesis on this.

What About the Rates Then?

Signing off with a brief tour back to my starting point I do not see the data supporting a BOJ raise in 2007. There are of course the Q4 2006 GDP figures still to come, and these are widely expected to show a considerable rebound in consumer spending, a rebound which might perhaps allow for an interest rate raise when we get to February. However, as oil prices are declining going into 2007 (and at the time of writing sharply so) this will have the subsequent consequence of bringing down headline inflation even further (and remember part of the issue in Japan is still that of finding a path to escape from the grips of deflation), so I am not very bullish on the future of Japanese inflation rates. Neither, by the way, is Takehiro Sato, who in the GEF post I linked-to at the very beginning of this note suggests that a return to some sort of negative price increase process is rapidly becoming more of a reality than simply a mere possibility. Thus I believe he makes a very valid argument in terms of whether the BOJ should raise in February on the back of 2006 Q4 GDP figures, whatever they may be. As such, I would be very wary indeed of pushing for a BOJ raise in February as I fear it could very well pull Japan back into the deflationary territory which we all so much wish to see it breaking out of.

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1. IMF - Global Inflation 2006, taken from the World Economic Outlook September 2006 (Figure 1.4).

2. Julien Seetharamdoo (2006) RBS - The Royal Bank of Scotland Group, What if the US consumer stops spending?

3. The Econonmist (2007) - Taking a Hint.