Japanese economic recovery: resilience, amid slow inflation

Economic data of late have shown more positive signals, from the upward revision in GDP to machinery orders and industrial production. While export growth has lagged, the trade gap has slowly narrowed and has even recovered (if temporarily) to surplus.  The BOJ meanwhile has placed emphasis on the recovery in housing investment from the growth side.


From the inflation standpoint, we are clearly on the lower side of BOJ expectations, though the composition of inflation does matter. The fact that soft energy and commodity prices have been keeping CPI low is a positive for commodity-importing Japan (refer to the recovery in trade, which adds to the GDP bottom-line). Moreover, wage inflation and low unemployment are reflationary indicators amid the low headline. We heard Gov. Kuroda mention this point in a speech in April, “in the 2014 shunto (spring wage negotiation), base pay was raised at many firms for the first time in about 20 years, and it looks likely that it will rise at even more firms in this year’s round.  Unemployment is on the lower side (latest reading around 3.3%) versus levels where inflation tends to accelerate (or NAIRU… which sits around 3.5%).

Monetary policy: continued investment recovery, unemployment and inflation expectations are key; energy prices less so

“The year-on-year rate of increase in the CPI is likely to be about 0 percent for the time being, due to the effects of the decline in energy prices.” (BOJ statement)

Since the May BOJ meeting we have seen the interim June statement, which basically sent a consistent message that QQE has been, for the most part, working.  There are some incentives – both positive and negative for the BOJ to remain relaxed about lower than target inflation for now, while leaving the door open to further easing if inflation (and inflation expectations) diverge from their upward trajectory.

The positive incentives to look beyond commodity-driven price softness are (as elaborated in a client presentation earlier this year):


The upside of slow inflation

–  Led largely by commodity prices, which is a boon for commodity-importing Japan

–  Lower risk of inflationary shock as path to fiscal crisis, even if fiscal credibility worsened with consumption tax hike delay.

–  Slower inflation means we can tolerate a comparatively weaker yen, which may help exports and overseas investment income, with a lag.

– BOJ quantitative easing contrasts aggressively with expected eventual tightening from the Fed (Q3, according to NABE survey); the contrast is in the BOJ’s favour (as it targets inflation).


Meanwhile, employment conditions also remain a positive incentive, as correctly identified by me, just about one year ago:




To highlight the BOJ’s emphasis on employment conditions and the relationship between unemployment and inflation, I cite Kuroda’s May speech in Portugal:


the negative correlation between unemployment and inflation is more apparent in Japan.”


The big negative incentive, of course, is that if the BOJ wastes its firepower by easing when things are generally going in an inflationary direction is that ultimately it will have to disappoint by running out of bonds to buy once GPIF and Japan Post have sufficiently reduced holdings.  Here, we take a look at the more recent June  “Bond Market Group” minutes; the main concern was that, despite a functioning JGB market, there has been a notable increase in bid-ask spreads and general decrease in liquidity since the start of aggressive “QQE” last October.  A liquidity crunch where bond issues become too scarce is perhaps not as bad as an inflationary bond-dumping shock, but could undermine BOJ credibility to offer further monetary support all the same.


Of course, we wouldn’t expect central bankers to voice this fear out loud, but reading between the lines, there are reasons to remain circumspect on marginal increases in BOJ bond buying from here.


Policy outlook:  The BOJ may well have to ease again, and it knows this (hence the wisdom of conserving firepower for when it can truly have an effect).  Part of the reason is because  the BOJ has committed to a high target.   The central bank’s own models of trend inflation, while recently adjusted upward, would be hard-pressed to show that 2% is in any sense, representative of “trend” inflation.  The idea of setting a higher-than-trend target of course is to push expectations higher.    An April Kuroda speech highlighted that inflation expectations are highly autocorrelated… experience of deflation/inflation influences future expectations, which is why the cycle is hard to break.  But empirical research shows that inflation expectations do not necessarily increase in a uniform manner, which is why we want to keep looking for signals of price rises ex-fuel and commodities, alongside wage rise expectations rather than merely headline or even core CPI.



Still, if we don’t see a pick up in inflation – or a justifiable signaled increase in inflation expectations  (and for this, I have my own indicator) –  by autumn, there is still possibility of further easing.


In short, where assessing the BOJ’s assessment of current and future conditions, look out for language on unemployment, inflation expectations and bond market liquidity.



The other two arrows: – fiscal and structural

Abe may well have pledged to prioritise growth over fiscal consolidation near-term, but he has wisely stuck by the once-delayed consumption tax hike in latter 2017.  The pledge for loose fiscal policy near-term complements the all-in BOJ strategy to reflate the economy; without reflation, there will be little chance to implement reform.  Yet we all know that reform is ultimately necessary, lest Abe miss his window, much like the Koizumi administration did after establishing the necessary consolidation of power and economic expansion from which reform becomes possible and publicly palatable.  If we are believers in Ricardian equivalence, delaying tax hikes alone should make very little difference – the combination of reflation (and implied fiscal tightening of inflating away debt) makes Abe’s near-term growth commitment more meaningful.  Otherwise stated, if Japan cannot implement the 2017 tax hike with confidence, having achieved a robust few quarters of growth, with a tighter job market and reflation well along its way, the fiscal consequences look much, much worse.


Structural reform: I cannot help but maintain my scepticism over Abe’s “third arrow”.  Although he does appear to be using the right “buzz words” (such as “prodctivity”), there still remains very little evidence that the administration recognises how to boost productivity.  For example, in the “Honebuto no Houshin” reform guideline that the Cabinet office has recently compiled, discussion of boosting innovation in the IT industry makes an appearance.  This perhaps sounds good – but much like “deregulate manufacturing” it merely picks winners.  As I have discovered in my own research into Japanese productivity, there is a gaping divide between IT-related industries’ productivity and those of non-IT related industries, even wider than the manufacturing-nonmanufacturing gap.  Unless we can address the “weakest links” (and this means non-IT), looking to achieve productivity growth uniquely through an already out-performing sector of the economy might, once again, prove a misguided policy.








Subscribing clients will have seen the composition of my structural reform assessment tool (rather than scorecard, as it is too early to say that structural reforms have been achieved, much less that they have had any true effect on productivity), and know that one of the items most conducive to upgrade is the Abe government’s consolidation of power and thus its ability to implement items such as change in corporate governance (via regulation as well as GPIF asset allocation).  This, as well as sources of gaiatsu (external pressure) for reform – such as TPP prospects – in my view remain the sharper of Abe’s structural reform tools.  Still, as it currently stands, my checklist still leads me to expect less than 50% chance of ultimate success in structural reform.


Outlook: positive expectations until 2017

Decent growth in the upper 1% annualised handle is widely expected for Apr-Jun quarter, which is healthy and above potential (somewhere around 0.5%), even though inflation is still anticipated to remain subdued (around 0%).  Watch for divergence in inflation expectations of ex-energy versus energy-inclusive core.


Inflation expectations: there are now expectations for inflation to near the 2% target in fiscal 2017, which is perhaps why Abe is emphasising easy fiscal conditions short-term.  Ricardian equivalence should mean that long-term, fiscal delays shouldn’t matter and Japan still needs to balance the budget, but in tandem with monetary policy (and cultivation of inflation expectations) this is a cyclical policy play.


Market expectations (looking at JCER’s ESP survey) remain divided on where we are in the cycle – some see the peak in growth as past, but others see the peak as still ahead (perhaps in 2017, alongside reflation)?  What market players seems to agree upon is that the trough in growth is behind us, which is positive given our focus on inflation expectations.


Consistently with rising inflation expectations, unemployment is expected to head steadily lower.  As I mention above, this sends a signal to the BOJ to “wait and see” for now.  If a cut does come, the expectation is that it should come in October.  Expectations for the BOJ’s next move to be easing rather than tightening still prevail.