Japanese Deflation is Far From Dead

Japan CPI

When Bank of Japan Chairman Haruhiko Kuroda took the reins of the Japanese central bank in late 2012, he was tasked with jumpstarting an economy that had been languishing since the 1990s. GDP growth was slow, the population was aging, and the government was one of the most highly leveraged in the world.

Most menacingly, deflation had crept into the economy. Well, not so much “crept” as “kicked down the door, laid down on the couch, and settled in for a decade”. Deflation is an insidious thing– it gets the economy caught into a trap where people don’t want to spend or borrow today because prices will go down in the future. It slows down future growth of the economy, making it even harder to get the economy healthy again.

Japan had tried a number of monetary policy tools in order to fight inflation: QE, lowering interest rates, direct bond purchases. None of them worked.

Kuroda recognized how big of a problem this is, so he announced a year ago that the Bank of Japan (with some help from Prime Minister Abe) would get 2% inflation in two years. A bold statement, but one that seems to be paying off. Kuroda has announced that Japan is on track to meet its inflation target. This is great news, right? Well, yes, but Japan is certainly not out of the woods yet.

Moving from deflation to inflation is one thing, but maintaining a healthy level is another. Japan’s newfound inflation could be a result of the depreciating Yen or rising energy prices. In that case, Kuroda will just have to hope that inflation expectations are ingrained enough by the time either of those factors change.

Furthermore, Japan is seeking inflation at a time of low inflation across the developed world. Europe is flirting with deflation and the US closed February with 1.1% inflation. Considering that both the US and Europe are major trading partners, Japan should feel concerned about external economic changes derailing the baby steps it has taken.

Japan’s fight against deflation, and fight for returned healthy rates of growth, has now reached a hill that must be climbed. Ideally, Japan will be able to establish inflation and inflation expectations such that domestic consumption increases, accelerating growth without relying on international trade. However, if consumption does not pick-up due to the  new consumption tax set to go into effect next week, a return of economic malaise in Japan’s European and American trading partners, or some other reason, then the BOJ’s progress will quickly be reversed.

Increasing consumption will be tough, though. Japan has a notoriously high savings rate and is facing some other headwinds. The new consumption tax (the result of  political games) won’t help, and neither will the aging population or government debt problem that will eventually have to be dealt with.

Kuroda did well to articulate that deflation is being defeated in Japan. He would do well to recognize how fragile this recovery really is.

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