After a protracted period of deflation from 1999 to 2005, Japan appears headed for falling prices yet again. Japan’s core CPI (which excludes fresh food prices, but not energy prices) rose 1.9% yoy in October – a drop from September’s 2.3% yoy rise. The consensus forecast is now that Japan will dip back into deflation (as measured yoy) in mid-2009, with many seeing a return to positive territory in fiscal year 2010/11. Nevertheless, there are reasons to believe deflation this time around might not be as temporary a phenomenon as some now believe.
Many analysts, such as Azusa Kato of BNP Paribas, see the coming fall in prices as different from Japan’s earlier deflation spell and therefore, conclude that it will be temporary.
Japan may fall into deflation next year but I think it will be temporary. That’s because Japan’s economic slump still looks shallower than around 2002 when it was last in recession with the jobless rate topping 5 percent and the economy’s supply exceeding demand far greater than now.
So what’s driving deflation and how ‘temporary’ are these factors?
Main Deflation Drivers In Japan
· Appreciation of the yen vis-à-vis world’s major currencies
(See related spotlight issue: Yen The Star Performer In Carry Trade Unwinding)
· Falling oil and commodity prices
(See related spotlight issue: Oil Price Outlook: Will Demand Destruction Keep Up with Supply Destruction?)
· Domestic recession (could be Japan’s worst in post-WWII period in terms of depth, according to JPMorgan)
(See related spotlight issue: Japan Officially Enters Recession: How Long And Deep Could It Be?)
· Loss of export growth engine due to global downturn
(See related spotlight issue: Japan’s Export Machine: Slowdown Continues)
· Sluggish real wages
(See related spotlight issue: Japanese Labor Market: Why Are Wages So Sluggish?)
· Anemic domestic demand
Why Japan May Not Emerge From Deflation Spell By 2010
Different from the previous deflationary period, Japan is facing both home-grown and external deflationary pressures this time around. And while a number of the deflationary drivers are arguably temporary, such as falling commodity prices or a strong yen, others are more deeply entrenched, which raises the question: how ‘temporary’ will this deflationary period really be?
To a certain degree, it’s unclear that Japan ever completely shook off deflation. While there is no doubt that consumer prices in general have been rising, the inflation trend evaporates when you strip out fresh food and energy and look at so-called US-style core CPI, which has been essentially flat, as depicted below. That is, rising oil and food prices, which peaked in July, did not really filter through to the rest of the economy.
Even when commodity prices were skyrocketing, companies had trouble passing on the higher costs to consumers because of Japan’s anemic domestic demand, which in turn is a function of sluggish real wages.
A turnaround in domestic demand is unlikely to come anytime soon due to falling real wages and long-term demographic trends. EIU forecasts real wages in Japan will decline for the third consecutive year in 2009. Meanwhile, Japan’s labor force of about 66 million people aged 15 or over as of 2006 is projected to fall by more than 10 million by 2030, as noted by Kosuke Takahashi in a recent Asia Times piece. This reduction in the labor force is likely to hurt, rather than help, anemic domestic demand.
The problem is the deflationary pressures Japan is facing all feed into one another -weakening exports put downward pressure on already anemic domestic demand, which in turn is likely to lead to a more prolonged recession, which in turn is likely to keep wages depressed. Essentially, this is an interconnected, vicious circle from which it’s very difficult to emerge. In a recent piece, Nouriel Roubini discusses this dangerous cycle of falling prices and falling production/employment/income and demand in the context of the U.S. and global economy.
So How To Break This Vicious Cycle And Prevent Protracted Deflation?
This is, of course, the big question worldwide. In Japan’s case, the Bank of Japan has almost no firepower left with the benchmark interest rate already at 0.3% (the lowest in the industrialized world). Meanwhile, Japan has two fiscal stimulus packages on the table, but it’s unclear how much of a contribution they will make in getting the economy back on a growth track. (See related spotlight issue: Japan’s Fiscal Stimulus Packages: Will They Boost The Economy?)
In Japan’s case, the toolbox of policy options is starting to look bare, but it’s not yet empty. According to BNP Paribas, further BOJ options include: bank prudential policy (purchasing of CP, shares held by banks), unsterilized fx intervention (in cooperation with the Ministry Of Finance), and quantitative easing, although it’s questionable how much of an effect quantitative easing would have. (See related spotlight issue: Is Quantitative Easing Returning To Japan?)
In sum, it’s not a foregone conclusion that Japan will be over its deflation bout by 2010, as several analysts are expecting.