The accession of Emperor Naruhito on May 1 launched a new imperial epoch in the Japanese calendar — the Reiwa, or beautiful harmony, era replaces the Heisei, or achieving peace, era that ran from 1989. After beginning in a mood of heady optimism, with absurdly overvalued asset prices, the Heisei years have been acutely disappointing for Japanese growth, inflation, equity prices and public debt.
Japan has become the world’s trial balloon in the saga of high debt and low inflation. In a recent column, Martin Wolf asked how the era of high and rising global debt might end. He suggested three main possibilities:
Prime Minister Shinzo Abe and Bank of Japan governor Haruhiko Kuroda have certainly made some progress along the third, optimistic, path since Abenomics arrived in 2012. Deflationary forces have been stabilised. However, even now, the nature of the end game in Japan does not seem clear. Instead, the economy remains mired in a state of suspended animation, where nothing gets much better, but no crisis ensues.
Lately, the economy has actually moved in the wrong direction (see box below). Real activity has stagnated since the turn of the year, and core inflation shows little sign of approaching the BoJ’s 2 per cent target even by the end of Mr Abe’s present term in two years’ time.
Much of the recent deterioration in real and nominal activity indicators has been concentrated in the manufacturing sector. Japan has become a major casualty from the disruption to Asian supply chains by the US/China trade war, and the consequent decline in Chinese capital investment spending.
This was initially seen as a temporary hit to Japanese manufacturing that would stabilise or reverse when the tariff war receded, but the latest escalation in the trade conflict could prolong and deepen the damage to Japan. President Donald Trump’s most recent increase in tariffs on Chinese imports will probably reduce Japan’s real GDP by 0.2 per cent in the next two years, and there could be worse to follow.
How should Japanese policy respond to the deteriorating economic situation? At its policy meeting on April 25, the BoJ announced that it would keep interest rates unchanged at least until spring 2020 and, since then, Mr Kuroda has hinted that this guarantee could be extended even further into the future. However, this form of central bank forward guidance seems largely irrelevant, since very few households or firms expect any increase in Japanese rates for many years to come.
Short of using the central bank’s balance sheet to purchase foreign exchange or equity exchange traded funds in much larger quantities, monetary policy finally seems to be out of ammunition in Japan.
A central problem for the economy is that inflation expectations are firmly stuck at zero, almost regardless of policy guidance from Mr Kuroda.
Younger-aged cohorts in the population have never experienced inflation much above zero, and their inflation expectations are much lower than those of older cohorts. Annual price changes for individual products are closely bunched around zero.
Very few companies believe that they can pass on higher wage costs to their customers. Wage increases, driven for example by well-intentioned increases in the minimum wage or male/female wage equalisation, simply induce employers to seek new technologies to enable them to shed workers. This is a trap from which monetary policy cannot easily escape.
That leaves fiscal policy. Mr Abe has placed much political capital behind a plan to raise the consumption tax rate from 8 per cent to 10 per cent in October, while offsetting the near term fiscal tightening (0.7 per cent of GDP, according to the IMF) by the permanent provision of free pre-school education, and a series of short-term spending measures.
This package is expected to have a much smaller effect on the economy than the consumption tax rise in October 2014, which was severely disruptive, but it would still involve some medium-term fiscal tightening. Given the latest trade wars, the downturn in global capital spending and the inability of monetary policy to respond, Japan may not be able to withstand any fiscal contraction at all this year.
Mr Abe has until the end of June to decide whether to change tack, either by postponing the consumption tax increase, or by increasing the scale of the offsetting increases in government expenditure. At the same time, he may announce that a lower house election will accompany the regular upper house poll in July, seeking a mandate for his economic and constitutional policies.
Mr Abe has been a risk taker in the past, and may be increasingly attracted to one final throw of the dice.
Activity growth has settled at close to zero in the past few months, after dipping temporarily into negative territory early in 2019. Disruptions in Chinese and other Asian trade flows surrounding the impact of tariffs on supply chains have been partly responsible.
Core inflation has risen by about half a percentage point since hitting zero during 2016. Headline inflation has risen over the same period by 0.8 per cent, driven by higher oil prices. However, on both measures, the outlook for inflation remains far below the Bank of Japan’s 2 per cent target.
Nominal activity growth in Japan, which can be viewed as an up-to-date proxy for nominal GDP, has been falling since the end of 2017, since the decline in real output growth has been greater than the rise in inflation.
On the core nominal activity measure, the rate of increase has now dipped to around 0.5 per cent, lower than it was at bottom of the 2016 deflationary shock. This is about 1.3 per cent below the government’s medium term target for its fiscal plans.
Source: This note is based on material which appeared in an article by Gavyn Davies published in the Financial Times on 19 May 2019.
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