Japanese Inflation: The Good, The Bad, and The Ugly

Inflation is rearing its ugly head around the world, keeping many central bankers awake at night. In Japan, by contrast, it has received an almost enthusiastic reception. Many see the 1.3% yoy rise in Japan’s overall CPI in May – the eighth straight rise and a 10-year high - as a sign the economy has finally emerged from a decade of debilitating deflation.

But perhaps it’s not time to break out the champagne just yet. Below are some thoughts on the potentially good, bad, and ugly sides of Japanese inflation.

The Good

Those cheering Japanese inflation see it as a potential trigger for unleashing domestic demand and thereby, supporting a wider economic recovery. Their argument, as reflected in this Bloomberg article, goes like this – consistent price rises should eventually filter through to inflation expectations. And once consumers expect prices to go up rather than down, they will have more incentive to buy now, tapping into their savings if need be, and less incentive to put off their purchases. This, in turn, should fuel consumer spending and boost Japan’s anemic domestic demand.

Optimists also point out Japan’s inflation (at just over 1% yoy) is of a particularly mild variety, when compared to price rises elsewhere (3.7% in the Eurozone, 4.2% in the U.S., and 7.7% yoy in China). Consequently, the Bank of Japan is not facing the same acute dilemma as other central banks, who are attempting to reconcile the conflicting demands of accelerating inflation and slowing growth. Given Japan’s relatively low inflation, the BoJ is expected to keep interest rates on hold until next year.

The Bad

Looking more closely at Japan’s rise in consumer prices, it becomes clear that inflation has been driven by food and energy price hikes. When these items are stripped out, it’s much less clear that Japan has really shaken off deflation, as shown by the graph below.

_{Source: Japan's Ministry of Internal Affairs and Communications}

Takeshiro Sato of Morgan Stanley thinks Japan’s “core-core” index - the equivalent of the U.S. core index in that it excludes food and energy - will barely scrape above zero this year. As Japan relies on imports for 60% of the food it consumes and 100% of its oil needs, the inflation seen so far has essentially been imported from abroad.

But couldn’t consumer price rises, even if fuelled almost exclusively by food and energy price hikes, filter through to other prices and still have a positive impact?

The short answer is: this could happen, but it doesn’t seem to be the reality on the ground as seen in the graph above. The jubilation of the inflation cheerers seems hasty. Ogata of Alliance Bernstein notes businesses have not had much luck trying to pass on costs downstream. Sato of Morgan Stanley agrees, noting that if prices of durable goods were to turn up, it would signify secondary inflation, which could foster expectations for rising prices and trigger consumption. But the reality is durable goods prices have been falling. He points out that consumer prices for items purchased more than 15 times a year (mostly food products) rose 2.4% yoy in April, while prices for items purchased less frequently than once every two years (mostly consumer durables) declined 0.9% yoy.

The Ugly

The potentially ugly side of Japanese inflation is that instead of boosting consumer spending, it could actually drag down growth. Imported inflation, via food and energy price hikes, may very well be suppressing domestic demand. The problem is that wage growth is accelerating only enough to offset inflation, as a report from Mizuho Corporate Bank points out. Official data show nominal wages growing an average 1.3% yoy for the first four months of 2008. This means wages were basically flat in real terms. So while inflation expectations may be shifting higher, as shown in some recent surveys, most consumers don’t have any more money in their pockets to spend. Nominal household spending actually fell in March, April, and May. In fact, spending by Japanese households in May slid 3.2% yoy, the sharpest fall since September 2006.

So where do you fall (no pun intended) on Japanese inflation – is it good, bad, or just plain ugly?

For more information on this topic, check out the following RGE clusters:

• Japanese Inflation: Good News?
• Where Are Japan's Consumers?