Stuck in a rut
21 March 2017
Earlier this year, we identified three criteria to be met before the Bank of Japan would consider raising its yield curve target. This included a 1ppt increase in core inflation, evidence that the drivers of inflation were sustainable and a meaningful rise in inflation expectations. On the first point, progress has already been swift with the January data pointing to the first positive core CPI reading in over a year: a 0.4 point jump from November 2016. This reflects a rise in fuel prices and a slowing of the rate of decline in energy prices to just -0.8% (see Chart 8). Looking ahead, this improvement is set to continue with energy price inflation to turn into a positive contributor to the tune of 0.3-0.4 ppts to core CPI inflation in the second half of the year. In this environment, it would not take a huge pick-up in underlying inflation to reach our hurdle for policy change. The key factor to watch here is the currency. Every 10% fall of the yen during the post-Abenomics depreciation has been calculated to add 0.2-0.3 ppts to core inflation. As long as the currency does not give up its recent 10% fall, we expect a similar impact on food and durable goods pricing going forward. Indeed, on our calculations we could find ourselves above the 1ppt threshold by July.
Turning to the question of persistency of any improvement in inflation, we are more concerned that the medium-term drivers of inflation continue to lack momentum. Even though traditional labour market measures point to tightness, estimates of the output gap indicate excess capacity. This latter conclusion is certainly more consistent with the recent Shunto wage negotiations. The pace of headline wage hikes slowed for a fourth straight year at 2.1%, while the base pay component was flat. What concerns us still further is that even during periods when the output gap has been in positive territory, such as in the mid-2000s, domestic inflationary pressures were relatively benign. Indeed, excluding forex or commodity related effects on prices domestic inflation in Japan has remained remarkably stable in recent decades, moving within a narrow ±0.5 range. For a decisive break we need to see an overshoot in the output gap and a meaningful change in the relationship between inflation and the labour market. Above-potential growth in 2017 will need to continue for multiple years. A global upturn and fiscal spending offer hope, but risks to the cycle are also rising, reducing the chances of a self-sustaining inflation pick-up within our forecast period.
The final consideration for the BoJ rests with the outlook for inflation expectations. Given the rebound in prices remains nascent it is little surprise that measures of inflation expectations remain muted. Household's inflation expectations for one-year ahead fell to 1.77% in February, compared to 1.84% in January. Elsewhere, the corporate sector price outlook has also been in freefall (see Chart 9). Overall, a price outlook consistent with 2% remains a distant prospect. Indeed, we expect inflation to reach just 1% by the end of 2018. This progress remains too slow to justify an increase in the BoJ's yield curve target over this period, without damaging its inflation targeting credibility. The one wildcard is the global interest rate environment. A material rise here, and subsequent depreciation in the Yen, could put pressure on the BoJ to lift its yield curve target, even though this would not necessarily raise the prospects for long term inflation.
Govinda Finn, Senior Japan Analyst