Challenges Confronting the Bank of Japan’s Attempted Reflation (2013)

Derek Holt and Dov Zigler, Scotiabank, Toronto.

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.