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Japan’s inflation target still a distant goal

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Bank of Japan (BOJ) Governor Haruhiko Kuroda attends a news conference in Tokyo, Japan, 16 June 2016. (Photo: Reuters/Thomas Peter).

In Brief

More than three years have passed since the Bank of Japan (BoJ), led by new Governor Haruhiko Kuroda, introduced the surprisingly aggressive monetary policy of quantitative and qualitative monetary easing or QQE.


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But the year-on-year consumer price index (CPI) inflation rate, excluding fresh foods, was −0.5 per cent as of June 2016.

This is largely due to the huge decline in crude oil prices; the CPI inflation rate will likely turn positive when the negative contribution of energy prices diminishes. Japan does not have to worry about the return of deflation.

Still, Japan seems to be a long way from achieving its 2 per cent inflation target. Although the BoJ maintained its inflation forecast for fiscal year 2017 at 1.7 per cent and reiterated that it may even achieve its 2 per cent target, few outside the BoJ seem to believe such a scenario. The private consensus forecast for the fiscal 2017 CPI inflation rate stands substantially lower, at 0.7 per cent.

There remains misunderstanding that the BoJ believes the simple monetarist logic that the increase in monetary base automatically raises inflation through broad money creation or inflationary expectations, which Kuroda has repeatedly denied. Rather, QQE was shock therapy, which assumed bold monetary easing might trigger substantial depreciation of the yen. A weaker yen would not only raise inflation, but stimulate demand and corporate earnings. If it accompanied a nominal wage increase, ‘the escape from deflation equilibrium’ might be accomplished. This is because inflation due to the depreciation of the yen is one-shot, while inflation due to increases in wages is sustainable.

Unfortunately, this trickle-down scenario didn’t materialise. The introduction of QQE did result in significant depreciation of the yen producing record high corporate earnings. But the increase in capital investment as well as nominal wages remained very modest. Annual wage increases, excluding regular increases in accordance with workers’ age, was around 0.4 per cent in 2014 and around 0.6 per cent in 2015. The increase in base pay in 2016 seems to be 0.3–0.4 per cent, even with record corporate earnings and an extremely tight labour market.

More surprisingly, a very slow wage increase occurred not just because companies were reluctant to accept higher wages, but largely because wage demands by labour unions were quite modest. Although wage increases for part-timers are relatively firm at around 2 per cent per year-on-year, wage demands by labour unions in 2016 often fell short of the previous year’s settlement. What blocked the ambition of Abenomics and QQE was the defensive behaviour of Japanese companies comprised of long-term workers.

Why do both companies and unions remain so cautious against the background of record high earnings?

It is evident that a new wave of innovation is now spreading all over the world — in artificial technology, the internet of things, financial technology and the sharing economy — but the response of Japanese companies has been irritatingly slow. It is often argued that the decline of Japanese firms started in the 1990s when they lagged behind in the information and communications technology revolution. But Japanese companies in that period were more on top of the technology wave than they are now — when Dell became the world’s top assembler of PCs, most of the componentry was made in Japan.

Besides US companies, many Chinese and German companies are now leading innovators, while very few Japanese companies are ahead of the wave. In the past, research and development on high-tech products like semiconductors or LCD screens could be made within a firm, and Japanese firms were very good at these types of technological improvement. But innovations in the 2010s are not necessarily high-tech, as many companies in the ‘sharing economy’ (such as Uber and Airbnb) demonstrate. The most important characteristic is innovation take-off beyond the border of companies and countries. Unfortunately, this is a challenge for Japanese companies with closed, long-term labour relationships.

Both companies and workers in Japan interpret the current high levels of earnings as being largely due to a weak yen and cheap oil, and doubt the competitiveness of their companies. They are right. It is no wonder regular Japanese workers, who typically expect to stay with their company for 20–30 years, refrain from demanding aggressive wage increases when they are anxious about the future of their companies, even if current earnings are very favourable.

The 1980s saw the introduction of the insider–outsider theory in labour economics, developed by Assar Lindbeck of Stockholm University. The theory suggests that even if the unemployment rate is very high the bargaining power of a labour union within a company is so strong that large wage increases can be obtained each year. Companies have no choice other than to pass on the costs through increased product prices, resulting in the co-existence of high unemployment and high inflation — stagflation.

The current state of Japan may be described as reverse insider–outsider theory. Since labour market conditions are very tight, wages for part-timers go up accordingly, but regular workers refrain from demanding wage increases, resulting in the co-existence of very low unemployment and very low inflation. For the reverse insider–outsider theory to hold, two conditions are necessary: regular workers are so specialised in firm-specific skills that their wage will decline significantly when they leave their companies, and the wage gap between regular workers and part-timers has to be large. These conditions are undoubtedly met in Japan.

If we understand the reasons behind the slow wage increase as above, achieving the 2 per cent inflation target through monetary policy alone will take a long time, and may be impossible. In addition, Japan’s economy is now at full employment and slow economic growth is simply the reflection of very low potential growth. Since Japan’s potential growth rate is estimated at 0.2 per cent according to the BoJ, and 0.3 per cent according to the Cabinet Office, 0.7–0.8 per cent average growth after more than three years of Abenomics does not suggest deficiency of demand. So a large fiscal package doesn’t make sense.

Reverse insider–outsider theory may also suggest the need for the Abe government to strengthen reverse income policy in conjunction with labour market reforms. To revive the confidence of companies and workers, as the government desires, what Japan will need is no less than a ‘new industrial revolution’.

Hideo Hayakawa is a senior executive fellow at the Fujitsu Research Institute in Japan.

This article appeared in the most recent edition of the East Asia Forum Quarterly, ‘Reinventing Japan’.

One response to “Japan’s inflation target still a distant goal”

  1. The insider-outsider theory is interesting. The continuing large difference in pay between full time, so called permanent workers and part time, so called temporary workers is especially relevant.

    The article fails to mention some other important reasons why Japan’s economy and wages are not growing. First, Abe has failed to implement any significant so called structural or labor reforms. He has not implemented any changes in tax policy, for example, which would incentivize corporations to raise wages 4-5% every year for the next few years. What about tax incentives to raise women’s pay so that it is really is more equal to that of men?

    Neither has Abe done anything about the fact that many companies have their employees work 80, 90, 100 hours of overtime every month without any increase in pay. Even when people die from the stress of this kind of workload, called karoshi, these companies continue to get away with this kind of exploitation of their employees.

    There has been a lot talk about the need to raise the birthrate in Japan. But like most everything else related to Abenomics it has been all talk and little real action. Abe would prefer for the BOJ to do the heavy lifting on the economy. He either lacks the expertise in economics himself and/or is more interested in dealing with collective self defense, reinterpreting the Constitution, dealing with Putin to get back some of the Northern Territories, etc. The latter may give him more ‘glory’ in the short run. But these won’t help the average Japanese improve their living conditions.

    The hapless efforts by the opposition parties to propose realistic but more active economic policy have allowed Abe and the LDP to continue to win elections. So, he feels little pressure to do more about the economy.

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