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Economic Research: Why Japan's Consumer Inflation Will Drop Back Below 2%


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Economic Research: Why Japan's Consumer Inflation Will Drop Back Below 2%

Japan is bucking the trend. While "cost push" pressures are raising headline consumer inflation globally, the recent (modest) increases in the country's consumer prices are likely temporary. Powerful structural factors contain this dynamic in the country. S&P Global Ratings expects consumer inflation to fall below the Bank of Japan's 2% target again in 2023, making a shift away from its highly accommodative monetary policy unlikely any time soon.

The hefty rises in consumer price index (CPI) inflation in the U.S., Europe, and elsewhere have prompted talk that Japan's consumer inflation might finally start to rise significantly. This is important because a substantial, sustained increase in CPI inflation would lead the Bank of Japan (BOJ) to change its long-running highly accommodative monetary policy. More convergence between Japan's monetary policy and that in the U.S. and Europe is likely to meaningfully bolster the yen.

Structural Forces Keep CPI Inflation Low

Cost-push pressures raised consumer inflation in Japan to 2.6% in July. But this is low compared with the elevated levels in the U.S. and Europe (see chart 1).

Japan's consumer inflation has been low for a long time, for good reason. Prices have remained suppressed because of the country's long history of muted growth in consumer demand, the low inflation expectations that this has created, and the prioritization of employment stability over wage growth.

Japan's personal consumption has been falling more than GDP in recent years. Hit heavily by the pandemic, real personal consumption fell on average by 1.5% per year between 2018 and 2021, compared with an average annual real decline of 1.1% in GDP. Amid such weak demand conditions, consumer-facing firms haven't felt confident raising prices. As a comparison, in the U.S., real personal consumption grew 2% on average in this period, while real GDP rose 1.4%.

Personal consumption has been weak over a longer period. This is in part because of a long-term decline in the share of labor income to GDP. In the 20 years to 2021, Japan's personal consumption grew on average 0.3% per year in real terms, less than the 0.5% average real GDP growth in this period (see chart 2). Thus, the expansion of consumption has been small even compared with the modest growth of overall economic activity and production. In the U.S., average annual real private consumption growth in this period of 2.2% exceeded real GDP growth.

Chart 1


Chart 2


The low CPI inflation in Japan in recent decades in these circumstances has led to low inflation expectations. Headline CPI inflation averaged 0.2% in the 20 years through July 2022, and "core core" inflation (excluding energy and food) 0.0%. In the U.S., headline CPI inflation averaged 2.4% in the same period and core inflation averaged 2.1%. This led to what the BOJ governor Haruhiko Kuroda has called the "zero inflation norm," [1] with companies reluctant to pass on cost increases for fear of losing market share.

This is especially true in the services sector, but "everyone… [is] acting essentially in concert to keep prices unchanged," said Mr. Kuroda in a speech. Notably, for example, internationally operating Japanese companies tend to use profits from overseas to subsidize domestic operations, allowing them to absorb cost increases rather than passing them on.

The Norms That Keep Consumer Inflation At Bay

Forceful legal and cultural norms discourage firms from implementing price increases that could result in lost market share. Labor laws and convention make it very difficult for companies to cut their regular labor force. Many employers and employees are focused on employment stability rather than wage increases. Firms keep employees in weak times; the flip side of that coin is that they pay relatively moderate wage increases in good times.

Persistently low wage growth has also weighed on CPI inflation. Wages--to be more precise, unit labor costs, the amount of wage costs per unit of product--are a key determinant of prices. Wage growth in Japan has been low for a long time, especially in the service sector.

Changes in the composition of the labor force have affected wage statistics, particularly the steep rise in the share of part-time and temporary workers.

Looking at the average wage per hour avoids most misinterpretation. On this metric, wages fell by an average of 0.2% per year between 2000 and 2015. They rose by an average of 2% per year between 2015 and 2020, in part because some large, profitable companies heeded government calls for higher wages. But most smaller companies, especially in services, have not been profitable enough to lift wages.

In any case, a recent reduction in the number of hours worked in recent years has helped to limit the impact of some increase in wages on unit labor costs. This reduction was mostly due to the replacement of retiring regular employees with part-time workers, or those on temporary contracts.

Sustained Rise In Core Inflation Unlikely

The sharp increases in global energy and commodity prices since 2021, combined with large yen depreciation, have sharply increased costs for many companies. A significant number of companies have raised prices for consumers, including for food products. This is testing the "zero inflation norm." Indeed, it is likely that more companies will raise consumer prices in the coming six months, including internationally operating firms that will see lower profits from overseas operations. This could in principle set in motion a process toward higher underlying inflation.

However, in our view the current price increases are largely cost-push pressures. A sustained increase in core inflation remains unlikely, especially given the headwinds to economic growth. In June, we forecast that CPI inflation would average 2.2% in 2022, and 1.4% in 2023.

The prevalence of subsidies and import restrictions also constrains consumer price increases. This dampens the effect of changes in global prices on prices faced by Japanese consumers. In the energy area, measures including price controls on electricity tariffs and gasoline and rail transport subsidies weaken the link with global prices.

As a result, in June, Japanese consumers faced 16.2% year-on-year increases in energy prices, compared with a 33.0% spike in the U.S. Import restrictions, which elevate the domestic prices of products, including rice and other grains, also suppress the effect of higher global food prices. Japanese retail food prices were 4.4% higher than a year ago, compared with 10.9% in the U.S.

While Japan CPI is brushing above the key 2% threshold, we find it more notable how low price-increases have been in the country amid generationally high inflation globally. Japan remains an outlier on this front. The economic structures that suppress consumer price rises in the country remain sturdy, and will continue as such.

End Note

1. The Bank's Thinking on Monetary Policy: Toward Achieving the Price Stability Target in a Sustainable and Stable Manner, Speech at the Kisaragikai Meeting in Tokyo, June 6, 2022

Editor: Jasper Moiseiwitsch

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