Japan: A Whiff Of Inflation?

Includes: EWJ, FXY
by: Blu Putnam

Japan has now printed two months in a row of its general rate of inflation above zero. The July nationwide CPI was 0.7% above its reading from one year ago, compared to 0.2% for June, and -0.9% as recently as March 2013. A combination of the yen depreciation and higher crude oil prices worldwide have been the main reasons for the move into positive territory. The core inflation rate, excluding food and energy, remains just below zero for the past year, at -0.1% for July 2013.

Our research suggests that core inflation could move above zero in the coming months, and may even rise to 1% for January 2014 (figures to be released at the end of February 2014). Our research does not see this short-term progress away from deflation as permanent unless a scenario develops which encourages further and sustained depreciation of the Japanese yen. While such a scenario is possible, fiscal policy may well complicate the path to higher inflation and improved economic growth.

Figure 1.

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Sales Tax Rise Decision

Prime Minister Abe's next big decision is whether to allow a planned increase in the national sales tax from 5% to 8% to go into effect in April 2014, and then to 10% in October 2015. When this staged sales tax increase was pushed through the Japanese Diet in the summer of 2012 by then-Prime Minister Noda, the intention was to shift more of the burden of raising long-term government revenues to a consumption tax. Japan's outstanding government debt is about 200% of its GDP, and a move toward greater fiscal balance appears critical for long-term financial stability. It is worth noting that Mr. Noda became a former Prime Minister after less than one year, in no small way due to his advocacy of raising the national sales tax.

Many economists in Japan believe the economy is now strong enough to power through this sales tax increase. Signs indicate that Prime Minister Abe will decide to stick with the planned sales tax increase because he fears a negative reaction in the market place to any back-tracking on raising revenues more than he is worried about the impact on the economy. While we are in the camp that sees Japan's government debt load as a very large and challenging long-term problem there needs addressing, we are not optimistic about the short-term impact on the economy from the tax hike. Our estimate is that January-March 2014 real GDP will see a sizeable boost from consumers making their purchases ahead of the tax hike. Unfortunately, we see the quarters after the tax hike being severely depressed with no quick recovery. Our negative prognosis for real GDP in Japan's FY 2014 suggests a very bumpy ride for Japanese equities over the coming 12 months.

Japan's fundamental growth challenge is that its labor force is no longer growing. Indeed, it is shrinking slightly each year now. The arithmetic of real GDP growth can be divided into three parts: (1) labor force growth, (2) capital investments that improve labor force productivity, and (3) increased labor productivity coming from technological improvements or management efficiencies. Japan gets no help from labor force growth. Japan is a modern country and so new capital investment can only provide a small boost to real GDP growth, say about 0.5% on average. Labor productivity gains from technology probably average about 1.5% per year, but such gains tend to happen in fits and starts.

Figure 2.

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By our reckoning, Japan's long-term average real GDP growth rate is probably around 2%. Certainly, there will be excellent years of higher-than-average growth, but also slower- or no-growth years. If this is an accurate description of long-term reality for Japan, then the currency is likely to be one of the key pressure points. That is, if economic growth falters, as we think it may starting with the likely national sales tax rise in April 2014, then Prime Minister Abe may have to decide whether to advocate another round of yen depreciation. The politics of the decisions that Prime Minister Abe will face next year, if our growth prognosis is correct, are very uncertain, indeed.

What we do know, though, is that the fate of Japanese equity markets has been tied to depreciation of the yen. Japanese companies own considerable assets throughout the world, and a yen depreciation raises the valuation of those assets in yen terms. A weaker yen also provides some lift for the export prospects of domestic production. That is, yen depreciation is a key part of the strategy to lift economic growth above long-run potential.

Figure 3.

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The effects of yen depreciation are also linked to consumption habits. Underpinning Prime Minister Abe's strategy is the concept that yen weakness can raise import prices and lift domestic inflation. Rising inflation would then break the deflation psychology that many perceive has been a barrier to consumption demand. Hence, the conflict between a national sales tax increase that will clearly dampen consumption, after a pre-tax burst of activity, versus the yen depreciation approach that has led to some small signs of inflation pressure.

All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the authors and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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