Inflation: Japan Joins the Crowd

The CPI in Japan in November fell by 0.1% with the closely watched CPI excluding fresh foods up by 0.1%. The all-item CPI rose by 2.8% year-over-year as the metric excluding fresh food was up by 2.5%. The CPI for all items excluding food and energy rose by 2.8% over 12-months. And that core measure of the CPI shows a steady deceleration in Japan's inflation rate from 2.8%, to 2.2% over 6-months to 2% over 3-months.

That progression, however, does not necessarily end of the debate on Japan's inflation rate. Japan’s concerns on the pace of inflation run deeper than just some three-month inflation progression. Inflation in the services sector in Japan continues to spread, a well-known problem for inflation since goods sector inflation tends to be more responsive in the short run and service sector inflation tends to be stickier. Goods sector inflation also tends to be lower because international competition in the goods market keeps prices in line; whereas services are wholly a domestic sector as there are few items in the services area that are subject to any kind of international competition.

A key issue in Japan has been where inflation would be settling. Before COVID struck Japan had been struggling with a long episode of weak prices and deflation stemming from various shocks and a shrinking, aging, population that fostered declining domestic demand. The Bank of Japan has been one of the few globally important central banks to express concern about its consistent missing of its target before COVID. The Bank of Japan was consistently undershooting its target and it was concerned about what that would do with its credibility. In contrast the Federal Reserve has been over its target for over 2 1/2 years following period of chronically undershooting in a more modest way. The Fed only talks about how it remains committed to its 2% target and never entertains for a minute the notion that its credibility might be undermined by its persistent missing of its target and its slow return to its target range.

After Covid the Bank of Japan wound up facing a different world where its inflation rate eventually rose. However, that didn't convince anybody because, in the US, the Federal Reserve called inflation ‘transitory’ when in fact it turned out to be still accelerating and sticky. The Bank of Japan didn't so much take a position on what inflation would do, as it became skeptical and wanted to watch the development of inflation closely to see what kind of monetary policy would be appropriate based upon how inflation was developing. Its long run of weak prices, concern about deflation, and the modest nature of the inflation it faced, all combined to give the BOJ policy flexibility.

The chart shows that Japan's core inflation rate never rose as much as inflation increased in the United States or in Europe. And while the inflation rate in Europe and in the US has come down, the inflation rate in Japan has only risen more modestly and transitioned into a plateau where inflation has been steady, based on the core rate. In the US, the core rate has slowed its transition to a lower pace while in Europe the core rate continues to drop at a relatively rapid pace.

As a result of these developments Japan finds its core inflation rate more or less in the same situation as other major money center central banks. Japan is no longer the outlier with deflation although the future remains unclear. Current developments in Japan's inflation trends seem to suggest an inflation in Japan is going to be a little bit stickier in the post Covid world than it was in the pre-Covid world. The Bank of Japan, which has had extraordinary policies in place and has engaged in a policy of yield curve control, is anticipating transition back to more normal ways of making monetary policy. The international financial community is focused on when this transition is going to occur. The more normal Japanese growth and inflation begin to look and the less distressed the situation appears, the more likely that the Bank of Japan will make this transition sooner rather than later.

And that's what it looks like is developing. It's beginning to look like the inflation picture in Japan is transitioning to something that is more normal globally and the Bank of Japan will soon be able to transition to a more normal monetary policy and drop its extraordinary policy of yield curve control. Along with this the BOJ will be able to transition monetary policy to a more normal level of rates and begin to hike rates to that end. To make this decision central banks are always focused on market expectations. And the case of Japan, something called the spring wage round will be key in determining what inflation expectations are like. The Bank of Japan will be able to see what bargaining between labor and management produces in terms of a wage rate. That will help to determine not just what inflation expectations are, but the pressures that will exist on inflation for the period ahead.