Economic Letter from Asia: On Japan

This week, we focus on Japan following last week’s decision by the Bank of Japan (BoJ) to raise interest rates again. That decision brings Japan’s central bank closer to policy normalization, supported by the latest inflation data. However, Japan still has a considerable distance to cover before fully exiting its accommodative monetary policy stance, with the real policy rate remaining deeply negative (Chart 1). A closer look at Japan's inflation dynamics reveals that the recent uptick in price pressures has been driven primarily by fresh food and energy, with specific food items seeing price surges due to supply issues and rising production costs. That said, non-"core core" inflation components continue to show inflation consistently above 2% (Chart 2).

The outlook from here is increasingly supportive of BoJ tightening, including on the wage front. Annual spring wage negotiations have resulted in rising wage hikes in recent years, with the wage-price dynamic beginning to unfold as the BoJ desired (Chart 3). More recent wage data also shows a broad-based increase, though the manufacturing sector was a laggard in November, amid ongoing challenges (Chart 4). Externally, Japan still has considerable ground to cover in terms of monetary policy compared to its G10 peers. The wide yield differentials between Japan and other economies continue to weigh on the yen, creating unfavourable conditions that impact both locals and foreigners (Chart 5). Finally, like other net exporters to the US, Japan faces ongoing tariff risks, with added uncertainty surrounding its investments in the US (Chart 6).

The BoJ’s January decision Last Friday, the Bank of Japan (BoJ) raised its policy rate by 25 basis points to "around 0.5%," marking the highest interest rates in 17 years. Leading up to the decision, markets had already priced in the rate hike, following signals from BoJ officials that further tightening was possible in January. In addition, the central bank released updated economic forecasts, now projecting slightly lower real GDP growth for fiscal year 2024 but higher CPI inflation for both fiscal years 2024 and 2025. The upward revision in inflation forecasts coincided with Japan's December CPI report, which showed a notable increase in price pressures, rising to 3.6% y/y, up from 2.9% previously. However, despite the BoJ's rate hike, Japan still has a long way to go before exiting its accommodative monetary policy stance, with the real policy rate remaining deep in negative territory, as illustrated in Chart 1.

Price and wage developments Digging deeper, the December uptick in Japan’s inflation appears to have been driven by a few key factors, including fresh food and energy prices, which surged 17.3% y/y and 10.1% y/y, respectively. The spike in fresh food prices was broad-based, with notable increases in specific foods, such as cabbage. Meanwhile, the rise in energy prices was primarily due to the expiration of government subsidies for electricity and gas. When stripping away the effects of these items, Japan’s “core core” inflation remained steady at 2.4% y/y, with services inflation still trailing behind (see Chart 2). Additionally, some non-fresh food items, such as rice, also saw significant price increases, driven by a combination of reduced supply and rising production costs. In response, the Japanese government is now planning to release some of its emergency rice stockpile to help cool prices.

The persistence of some services inflation is a positive sign, even though that sector’s price pressures remain relatively muted compared to other categories, as discussed above. This is still significant, particularly given the strong link between service costs and wages, as many service sectors are heavily reliant on labour inputs. Moreover, wage growth in Japan continues to be a key factor in the BoJ’s decision-making process as it normalizes policy. The central bank sees wage growth as crucial to achieving its goal of establishing a "virtuous cycle" between wages and prices. With that in mind, investors are once again turning their attention to this year’s major wage-related event: Japan’s annual Spring wage negotiations, or “Shunto.” There is growing evidence that such a cycle is beginning to play out in Japan, with wage developments becoming increasingly encouraging in recent years (see Chart 3). Notably, 2024 was particularly promising, as wage negotiations led to the first wage increase of over 5% since 1991. Ahead of the year’s official figures, investors will likely look to leading indicators, such as wage increases reported by Rengo, Japan’s largest labour union.

Ahead of the spring wage negotiation results, we turn to more recent wage developments. As shown in Chart 4, wage growth in Japan, measured by total cash earnings, has remained robust over the past year, with the latest reading at 3.9% y/y in November. Nominal wage growth has been strong and broad-based across sectors, though wage growth in manufacturing lagged, as it faces ongoing challenges. Also, real wages are still struggling to maintain positive growth, despite significant gains in nominal wages, as inflation remains strong.

External developments We turn next to external developments concerning Japan. As mentioned earlier, the BoJ still has a long way to go in its bid to normalize monetary policy. This is particularly evident when comparing the BoJ’s current policy stance—still considered loose—to those of its G10 peers, who have already begun easing after completing their tightening cycles. As a result, Japan’s yields remain very low compared to those of its peers (e.g., the US, UK, etc.), making yield differentials unfavourable to the yen and contributing to its depreciation. The effects of a weak yen are being felt by both locals and foreigners. A cheaper yen has been a key driver of the ongoing tourism boom in Japan (Chart 5), but it has also partially driven higher prices for goods in Japan due to imported inflation. While last Friday’s BoJ decision triggered a mild bounce in the yen, it has yet to fully recover from the levels seen, for example, in September of last year.

Additionally, like many other major net exporters to the US, Japan faces risks related to trade actions under the hawkish stance of the new Trump administration. While no explicit trade actions have been announced regarding Japan, it remains uncertain whether President Trump will follow through on his repeated campaign proposal for blanket tariffs on all foreign imports. Beyond these potential tariff risks, other aspects of US-Japan relations are still in limbo, particularly concerning Japan's direct investment in the US, where Japan already holds a significant position (Chart 6). Of recent note is the fate of Nippon Steel’s attempted acquisition of US Steel, which was blocked by former President Biden.