Economy in Brief

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.

The S&P composite PMIs in January improved across the board, with the exception of India and the United States. In the U.S., the PMI headline dropped back sharply on sharp weakness in the services sector in the month in the face of what had been resiliency and strength.

From roughly February to July of 2024, the persistence of declines by sector especially in manufacturing diminished. However, now things have shifted, and we are again in a period when there seems to be more deterioration. The prevalence of manufacturing AND service sector deterioration together has reappeared.

The Russian invasion was a real catalyst of change for the EU, Germany, France, the United Kingdom, Japan, and the United States. Before Ukraine, the recovery from COVID was under way and both services and manufacturing sectors were running policies that left each sector with 50% or higher ranking in 60% to 100% of countries. After Russia’s aggressive action, both sectors were crushed across all these countries; the service sector rebounded first and from March 2024 to date services stood at a ranking above 50% or more in 60% to 100% of the countries. But in the post-invasion environment, the manufacturing sectors showed only about 20% of reporters above a 50% queue standing for manufacturing. Manufacturing continues to be hard hit and well short of normalcy.

Currently we are in another round of weakness looking at a broader group of early reporters that adds India and Australia into the mix. Still, six-month changes show weakness in at least two of three months or three of five months for manufacturing and service sectors. Together they are falling over the same six-months. The ‘best performance’ on this metric apart from the U.S. is Australia where manufacturing has improved on balance over six months for two months running but only after three months of deterioration on that basis.

U.S. performance is an outlier in several ways. The US service sector fell sharply in January, depressing services as well as the composite metric. But over six-months both US services and manufacturing have failed to worsen together for 16-months in a row.

The U.S. has been an anomaly in terms of international performance characteristics. U.S. manufacturing is weakening on balance over six months in six of the last seven months. But the service sector has risen on balance (over the previous six months) in 12 of the last 13 months.

The new sharp weakness in U.S. services (month-to-month) is an issue of it has any staying power.

The four-year queue standing of the manufacturing across eight countries and three sector readings (for each: two sectors plus a composite) shows only five of 24 of these rankings with standings above the 50% mark (above their respective medians) over the past four years. These readings are manufacturing in India (79.6%), services in Germany (63.3%) and services in the EMU (barely…. at 51.0%), and a 59.2 percentile standing for Japan’s service sector (the same for its composite).

EU order trends ‘improved’ slightly in January as the net diffusion reading rose from -40 to -34. Still, that improvement leaves orders below their 3-month, 6-month, or 12-month averages. The queue standard of January orders is in the lower 14th percentile of its historic queue of data. Obviously, it remains a historically weak reading. The order series is volatile as the chart shows. But it is still in a clear downtrend even with the uptick this month.

Export orders have approximately the same profile as for orders overall. But export orders weaken slightly in January compared to December. Export orders overall have a slightly weaker queue standing than total orders at a 13.4 percentile level.

The diffusion readings for stocks of finished goods weakened in January but even with its weaker January assessment, stocks have a firm-to-strong 72.5 percentile standing.

Looking ahead, the outlook for output volume over the next three months improved sharply from its stunning weak reading of -31 in December. However, the rise to -19 in January represents only a 4.8 percentile standing.

Unfortunately, average output prices for three months ahead has reading of +27 in January, up from +23 in December and +11 in November; the backtracking in prices expected, has brought the expectation level for the current reading to a high, 90-percentile standing. These rising inflation expectations are going to be a real problem for the Bank of England.

IP data lag the CBI survey responses. The manufacturing IP growth rate, year-on-year, has a 17.4 percentile standing as of its most recent observation in November 2024. That is also very weak. The CBI results are not giving a different message from the industrial production data, but they are timelier.

The ramp up in inflation expectation is not good new with CPI-H inflation at 3.5% year-over-year and with the core pace at 4.2%. Core inflation, sequentially, is looking stable around the 4.2% pace; for the headline, the pace has accelerated from 3.5% over 12 months to a pace of 5.4% over three months. These results, coupled with the rise in CBI expectations, are not good news for the U.K. or for the BOE.