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Hello. This week I’ll look at some exceptions to the normal rules of economics: specifically, that wage-price spirals can be good and deflation is not always bad. The main part is about Japan, an economy that we also so often dismiss as an outlier, as I did last week. There is now the tantalizing prospect that it could soon lose its special case status, but it is still too early to be confident.
What are your favorite examples of deviations from normal economics? Email me at email@example.com.
Japan becomes European?
Let’s summarize first. Japan’s real estate and stock market bubble burst in the early 1990s, leaving the economy with persistent low growth, rock-bottom interest rates and periods of deflation. It is wrong to consider the 30-year period thereafter as a uniform period. Instead, it was divided into distinct but reinforcing chapters: a financial crisis in the 1990s, mild deflation in the 2000s, and the struggle to prevent a decline in the workforce due to an aging population in the 2010s.
As the chart below shows, prices at the start of 2013 were exactly the same as 20 years earlier, even though Japan was aiming for low and stable inflation – 2 percent per year. Even with mild inflation thereafter, they were only 6 percent higher at the start of 2022 than in 1993. With inflation so low and a persistently weak economy, Japan’s monetary policy led the world in extraordinarily loose monetary policy. Beginning in 1999, the Bank of Japan pioneered zero interest rates, then quantitative easing, negative interest rates, quantitative and qualitative easing, and yield curve control in repeated aggressive efforts to reduce longer-term borrowing costs. But low inflation ended last year when it picked up for the first time since the bubble burst in 1990, with prices rising 6 percent in less than two years.
The reasons for the price increase in Japan are pretty clear. The country has not been able to escape supply chain difficulties and energy price increases that have driven up global commodity prices. And that initial increase in food, commodity and energy costs has spread to core inflation, with the most recent national inflation rate at 3 percent in September and core inflation, excluding fresh food and energy, at 4.2 percent. Japan has not had a core inflation rate that started at four since 1981.
So are Japan’s deflation problems over?
The best answer is BoJ Governor Kazuo Ueda, and Martin Wolf asked him exactly that question at the Financial Times’ virtual Global Boardroom conference last week. Ueda was cautious, saying that while deflationary threats are not a thing of the past, the country is almost at a point where it can say it has sustainably raised inflation to near the 2 percent mark per year.
Why the caution?
Ueda explained that there are two drivers of higher inflation in Japan. The first reason was higher prices for imports, which affected domestic prices. These were partly caused by the Japanese yen’s 25% decline in value since 2020 on a trade-weighted basis, as shown in the chart below. This effect is “wearing off,” said Ueda.
The second effect is a welcome wage-price spiral, he added. Ueda called for higher wage growth to keep price increases sustainable at 2 percent a year, saying: “We would like to see wages spill over into domestic prices.” Unlike other central bankers who do not want the high Inflation is reflected in wages, which is exactly what the BoJ wants to start doing to make Japan’s macroeconomy more normal.
Ueda said there is still “a long way to go” before he can be sure that the modest wage-price spiral will continue, and he is watching the spring 2024 wage round with great interest. The BoJ has raised its inflation expectations for fiscal 2025 to 1.7 percent from 1.6 percent in its July forecasts, showing it is nearing the point where it can say it has made its low inflation problem permanent has solved. In the summer of 2022, the BoJ thought it was just on track to raise longer-term inflation to 1.1 percent.
Things could even be a little better, as demand in the Japanese economy received a potentially helpful boost from the government’s new stimulus package following the monetary policy meeting. However, views on the effectiveness of this stimulus package and its desirability vary (a sharp editorial in the Financial Times said it was ill-timed).
What’s next for Japanese politics?
As long as the economy holds up in the coming months, everything depends on the wage round in the spring. Japan’s powerful business lobby Keidanren last week signaled its members’ intention to seek salary increases of 4 percent, matching a similar effort this year.
Should Japan enforce its wage-price spiral, we can expect the BoJ to move from its gradual easing of yield curve control to raising interest rates from the current negative level of minus 0.1 percent. Ueda made it clear that it was “a serious challenge” to achieve this safely after so many years. In my opinion we should not expect an aggressive BoJ.
It could also do next to nothing to tighten monetary policy – something like a purely symbolic increase in interest rates to 0 percent. But as the chart below shows, the largest companies’ big ambitions for wage increases often do not translate into wage increases for all workers, especially in smaller companies. Worse, wage levels are not keeping pace with inflation, so it is not correct to say that Japan has already achieved the desired wage-price spiral.
As Ueda told the FT, the bigger risk is still that Japan fails to escape its 30-year low inflation trap. The governor said he can raise interest rates if inflation rises too high, but if it falls below “it’s pretty difficult to deal with.”
All seven BoJ governors have known this since 1990.
A chart that matters – good deflation
Deflation is bad, right? Normally yes, because falling prices make it more difficult for companies to service debt that does not lose value. If household borrowing coincides with falling wages, it will also become more difficult to finance them, which can lead to a vicious circle of rising real debt, defaults and further declines in wages and prices.
But if overall prices fall because we become more efficient in production, supply costs fall, or import prices fall, then deflation is great. Things are getting cheaper; we become richer. So China’s slide into deflation of 0.2 percent in the year to October, caused by a 30 percent drop in pork prices, is really nothing to worry about unless you’re a pork producer hoping for hefty returns. In fact, it is literally a pig cycle, with many piglets being raised when prices were high, leading to oversupply and falling prices. Deflation in the Netherlands and Belgium in October was also caused by falling energy prices and a positive boon for their citizens. To cheer.
If you disagree, let me know at firstname.lastname@example.org.
What I have read and seen
Federal Reserve Chairman Jay Powell highlighted the communication difficulties I outlined last week dampen expectations a relatively quick US interest rate cut, as did European Central Bank President Christine Lagarde when she spoke to the Financial Times. For those who want to see Powell’s remarkable ability to engage in direct and sweary communication when he wants, watch the film The (7 minutes, 40 seconds). You know who you are.
In one gloomy blogThe IMF believes that job growth in Europe is likely to get out of hand, although it has been much higher than that in the US. Given the low productivity growth, the prospects for non-inflationary wage growth are limited.
Over at Unhedged, former New York Fed chief Bill Dudley agrees with me that money is not the big harbinger of inflation and worries about an impending US financial crisis.
In London, the Bank of England unveiled a new geopolitical stress test for banks that saw bond yields rise sharply. Given the similarity of the moves to when Liz Truss was prime minister, it looks like the central bank is ensuring the financial system can cope with another crazy turn in British and world politics.