Markets are too aggressively
assuming that the Bank of Japan’s (BoJ) latest attempt at reflating
the Japanese economy will succeed.
The Bank of Japan’s aggressive monetary easing faces numerous hurdles
on the path to achieving a higher promised 2% inflation target. We think
that markets may be overly optimistic regarding the ability to generate
the higher inflation and higher nominal company earnings that would come
anywhere close to justifying:
1. the over 50% rise in the Nikkei since it picked up on policy expectations
last November (over 25% in US$),
2. the roughly 25% depreciation in the yen against the US$ since September,
and
3. a sharp pick-up in market inflation expectations (chart 1).
Chart 1: Japanese Break-even Rates: Markets Not
Yet Pricing In 2% CPI

Source: Bloomberg, Scotiabank Economics.
In a nutshell, we believe that the BoJ’s policies
may stoke improvements in exports and hence the volume of net trade with
positive implications for growth, but would do so at the expense of the
outlook for consumer spending. That’s because BoJ policy could well
feed a relative price shock via higher energy import costs that will crowd
out other consumer spending while other forces weigh against the pass-through
benefits of easier monetary policy. In particular, soaring electricity
prices due to a policy bias against nuclear power will add to near-term
inflation upsides that we think will ultimately turn disinflationary after
non-energy spending is crowded out. Blocked monetary policy transmission
channels through credit markets, unfavourable demographics, and limits
to the ability of fiscal policy to effectively complement monetary policy
round out the forces confronting the BoJ’s policy efforts.
1. Japan Has Tried Before — Without Success
The first point is to acknowledge an argument often made by former BoJ
Governor Shirakawa. Two percent inflation was achieved in late 1997 and
early 1998, as well as 2008, but the experiences were always very fleeting
(chart 2).
Chart 2: Yen Depreciation & Higher Inflation
Have Been Fleeting

Source: Bloomberg, Scotiabank Economics.
2. Japan Won’t Get The Type Of Inflation
Shock It Wants
One way in which it is hoped that Japan might be more successful at generating
inflation this time around is through the impact of yen depreciation.
A depreciated currency can make the prices of imported goods more expensive
to domestic consumers — all else equal.
As chart 2 shows, large bouts of currency depreciation using the nominal
trade-weighted effective exchange rate of the yen versus a basket of the
currencies of its trading partners have indeed been associated with accelerated
rates of inflation. The fact that these periods have never carried lasting
consequences, however, may be due to how yen depreciation works in terms
of first-round and second-round effects on inflation.
Empirical attempts at measuring the pass-through effects
of yen movements into import, export, and consumer prices over a period
of about two years tend not to support the view that yen depreciation
can sustainably stoke domestic inflation.1
As demonstrated in table 3, using the results of the 2012 study we cite
page 26 [Shioji, 2012], the pass-through to total import prices across
all goods categories is higher than it is for export prices; for each
1% depreciation in the yen, total import prices rise by about the same
1% (i.e., 100% pass-through of the effects of yen depreciation) but the
pass-through on export prices is lower at about 0.4% (i.e., 40% pass-through).
This might suggest that large imported price inflation can result on net
from yen depreciation and is consistent with what was observed in table
3.
Table 3: Estimated JPY Inflation Pass-Through
Factors (2012)

Source: Japan MoF, Scotiabank Economics
The caveat is that, by import category broken apart in
table 3, the pass-through effect is greatest for combined intermediate
goods and raw materials, and most of that in turn is driven by the pass-through
to raw materials. Much of that is driven by energy products like higher
gasoline prices. All of the strong pass-through effects into early stage
inputs of raw materials and intermediate goods is then apparently absorbed
in profit margins or mitigated by domestic product substitutes where applicable.
This is evidenced by virtue of the fact that the pass-through effect of
yen depreciation into ‘final’ imported and domestic goods
prices is very weak. The table breaks out this pass-through effect for
consumer durables, consumer nondurables and capital goods and shows that
in each of these categories, every 1% depreciation in the currency has
tended to yield less than one-twentieth of that effect on prices, or zero
in the case of big-ticket consumer durables over recent years.
One risk implicit to yen depreciation is therefore that Japan may not
get the inflation that it wants. Instead of motivating a broad-based improvement
from deflation toward 2% generalized inflation, Japan could well incur
a relative price shock via higher imported energy prices that crowd out
pricing power for the rest of the economy. Given short-term household
budget constraints, this turns toward becoming broadly disinflationary
on the second-round effects as households substitute toward spending more
on what they have to (like energy and other raw materials) and relatively
less on discretionary items (like cars, appliances, etc.). Indeed, past
periods of faster inflation have tended to depress real wages as nominal
wage growth fails to keep up (chart 4). In turn, that saps pricing power
for the rest of the economy. Whereas there has been limited pass-through
to final goods prices as it seems that domestic companies have simply
absorbed commodity price shocks in the past, the pass-through from the
yen to raw-material prices is strongest, and raw material imports are
an increasingly important chunk of Japan’s total import bill —
and its CPI (see table 5). In fact, mineral fuels combined account for
almost a 40% weight in Japan’s imports. In the wake of the Tohoku
tragedy and the shut-down of Japan’s nuclear energy apparatus, natural
gas imports have surged. A weakening yen and fairly stable natural gas
and fuel prices will combine to feed CPI through the commodities channel,
sapping real wealth without necessarily stoking more economic activity.
Chart 4: Japanese Inflation Eats Away at Real
Wages
Source: BoJ, MoHLOW, Scotiabank Economics
Table 5: Japan: Import Shares, February 2013

Source: JETRO, Japan MoF, Scotiabank Economics
3. The Hope Is An Improvement In Net Trade
The benefit from the weaker yen is supposed to come via export competitiveness.
The study [Shioji, 2012] estimates a fairly strong pass-through from yen
moves to export prices. For capital goods, the pass-through rate is 50-60%;
for consumer durables, the pass-through is estimated at 40-50%; for consumer
nondurables, the pass-through is estimated at about 30%. The caveat here
is that Japan’s export prices in general have fallen for the past
30 years, so it’s hard to know whether the responsiveness of export
prices to currency changes has just been a result of the general downward
trend in export prices — or a response to the currency. The bottom
line is that Japan will require very strong export price pass-through
to compensate for what is sure to be a significant shock to domestic prices
of imported commodities. The evidence works against this argument through
the historically much larger pass-through on headline import prices (mostly
through raw materials) than export prices. Therefore, the impact upon
profit margins could perversely become negative for energy-intensive sectors.
The hope, therefore, is that export volume growth will
make up for higher import costs and squeezed margins for some producers.
As table 3 also demonstrated, the real, or inflation-adjusted volume of
imports is less impacted by yen depreciation than the real volume of exports.
That is, Japan’s real trade balance should get a lift from yen depreciation
and this could well assist in lifting GDP growth that is rooted in volume
concepts. That would be a positive, but one that would be offset by the
imposition of a relative price shock that would harm the consumer’s
impact upon GDP growth.
The additional caveat that we would add to the study is that most of the
in-sample yen depreciations are fairly modest and today’s sharp
depreciation in an atmosphere of a fairly slow-growing global economy
has few precedents and is essentially ‘out of sample.’
4. Money Creation Channels Are Still Blocked
The ability of an easier monetary policy to generate inflationary pressures
is also dependent upon well-functioning credit creation channels. Otherwise,
all the money in the world can be printed and rates will be close to zero
across the whole term structure but the money printing will be hoarded
within the financial system and/or put right back to the liability side
of the central bank’s balance sheet as is generally the case in
the US where excess reserves held by banks at the Federal Reserve have
blossomed. What this hope runs up against is the fact that monetary policy
transmission channels remain blocked in Japan. As chart 6 demonstrates,
money multipliers – in this case defined as M2 plus CDS over the
monetary base – and velocity have been in structural decline since
the 1990s and are not signaling any recent improvement. As long as monetary
stimulus fails to migrate through credit creation channels, sustainable
inflation pressures are unlikely to be generated whether we are referencing
Japan or other countries.
Chart 6: Monetary Policy Transmission Channels
Remain Blocked

Source: Bloomberg, Scotiabank Economics.
5. Older Consumers Will Limit Inflation Pass-Through
One other factor determining the ability of the country’s consumers
to absorb price increases is governed by where they are in the life cycle.
Younger households with faster growth in productivity and wages and who
are entering peak years of consumption would be better able to tolerate
some forms of higher inflation. Japan’s challenge is the opposite
(chart 7).
Chart 7: Japan Dependency Ratio: Highest in G-7

Source: World Bank, Scotiabank
6. How Electricity Policy Evolves Will Also Be
Key
Because of the desire to shut down Japan’s nuclear generating capabilities
in the wake of the Fukushima/ Tohoku disaster in March 2011, electricity
prices have been rising to over 2-3 times higher than in markets like
the US and South Korea, and further increases lie ahead. Chart 8, captures
electricity prices as reflected in the country’s CPI index and as
such understates the greater increase in raw electricity prices before
adjustments such as accounting for subsidies and intensity of use. Regardless,
electricity prices within CPI have risen by 10% since 2010 with more hikes
on the way this year. As the country faces whether to suffer further electricity
price shocks in a weak economy or bring back lower marginal cost electricity
production via the nuclear option, the role of electricity prices in driving
inflation higher or lower hangs in the balance. As Japan takes steps to
deregulate the distribution side of electric power markets, this could
combine with ultimately bringing back nuclear power plants and thus put
downward pressure upon electricity prices and inflation in a manner that
offsets the BoJ’s attempts to reflate the economy. This then depends
upon whether falling electricity prices motivate stronger pricing power
elsewhere in the economy. If this does not happen and electricity prices
continue to rise or remain high, then they risk reinforcing our earlier
arguments regarding the disinflationary consequences to other consumer
prices by crowding out spending power through higher electricity prices
and higher prices for imported raw materials, namely, oil and natural
gas. That, in turn, might also depend upon how quickly countries like
the US and Canada can ramp up liquified natural gas (LNG) exports to Asian
markets.
Chart 8: Bringing Nuclear Reactors Back Could
Be Disinflationary

Source: Bloomberg, IHS, Scotiabank Economics.
7. Fiscal Policy Limits To Complementing Monetary
Policy
Our final point is that the Bank of Japan has leaned back upon the government
of Prime Minister Shinzo Abe by stipulating that success in efforts to
reflate the economy cannot rely exclusively upon monetary policy. Fiscal
policy must also be employed, and it has been in the January 2013 Supplementary
Budget. While Japan’s stretched fiscal position (chart 9) has to
date not invoked much by way of market turmoil, it is a significant constraint
on the ability of the government to further reinforce monetary policy
stimulus without aggravating bond markets which would carry offsetting
implications for the economy against stimulus efforts. To Japan’s
defence, however, it also has a strong financial asset position to net
out against some of its indebtedness, and over 90% of its debt is domestically
held by a relatively captive investor base. At about 250% of GDP, however,
one would not wish to go too far in dismissing Japan’s deep-seated
long-run fiscal challenges nor the interplay between high government debt
and heavy ownership by domestic financial institutions that has not ended
well elsewhere.
Chart 9: No Room For Fiscal To Complement
Monetary Policy?

Source: IMF, Scotiabank Economics.
Our bottom line is that Japan faces significant challenges
in its efforts to reflate its economy. While wishing the best to BoJ officials
in their quest to ‘end deflation now’, we cannot help but
be reminded of one of Milton Friedman’s most famous lines: “Monetary
policy is not a panacea for all our ills. But steady and moderate monetary
growth would make a major contribution to economic stability and to the
avoidance of both inflation and deflation.” Whether the present
BoJ monetary policy actions meet Friedman’s standard remains to
be seen.
The authors wish to thank Scotiabank Senior International
Economist Tuuli McCully for comments shared on a draft of this note. Accountability
for the end arguments remains with the authors.
Notes
1 Etsuro Shioji, “The Evolution
of the Exchange Rate Pass-Through in Japan: A Re-evaluation Based on Time-Varying
Parameter VARs,” Japan Public Policy Review, Volume 8, No.1, June
2012.
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