Japan’s core CPI (which excludes perishables) surged 0.7% y/y in July, but the upturn is largely due to higher prices for energy that reflect rising import prices due the yen’s weakness. Despite global exuberance at Abe's "progress", BNP notes that there are still no signs of price growth for rent and service prices, factors behind Japan’s protracted deflation. Crucially, BNP believes that Abenomics could lead to four possible medium-term outcomes: (1) Continued deflation (35% probability), (2) Financial repression (40%), (3) High inflation (15%), and (4) Happy end to deflation via revived trend growth (10%).
Via BNP Paribas,
Scenario 1: Continued deflation (35% probability)
Currently, prices are rising largely because of imported inflation, though improvements in the output gap on the back of Abe’s fiscal spending also play a small part. Although we noted above that monetary easing alone cannot generate inflation, the job can, theoretically, be done via deliberate yen depreciation and continued fiscal spending. History shows that when deflation gives way to inflation, substantial currency depreciation is observed. But to deliberately debase the yen further would be very hard as other countries would certainly object strongly. More fiscal spending, meanwhile, is also a big problem given the fact that Japan’s public debt is already 200% of GDP. So if deliberate yen depreciation and additional fiscal spending are off the table as being taboo, deflationary pressures will likely reassert themselves once the effects wear off from the current fiscal stimulus and yen depreciation, as there are no other factors fostering price growth. Japan’s condition of deflation, low interest rates and a strong yen would remain unchanged. And because the effects of Abe’s growth strategies will also be limited (as indicated later), the trend growth rate would remain low. This scenario of continued deflation has a probability of 35%.
Under this scenario, the economic euphoria, yen depreciation and stock market rally triggered by the BOJ’s new dimension in monetary easing (QQE) will be found to be just momentary things based essentially on placebo-like effects. On this score, ever since stock market corrections began from late May, various sentiment indicators have peaked out and started trending lower. Of course, placebo-like effects are not the only reason for resurgent share prices and yen depreciation, as there have been changes in economic fundamentals, like the sharp drop in Japan’s current account surplus and the subsiding of the EU crisis. Consequently, both the Nikkei and the yen rate are unlikely to revert to their levels of last autumn.
The BOJ’s Kuroda has declared that open-ended easing will remain in effect until 2% inflation is achieved. Because of this, many might feel that this scenario should not have a very high probability. But, as pointed out above, because the long-term interest rate is already very low, no matter how much the BOJ inflates its balance sheet with aggressive purchases of long-term JGBs, the effects will be meager. The asset balances of private financial institutions do not change, as JGB holdings are only exchanged for BOJ current account deposits. Taking the balance sheets of the BOJ and private financial institutions collectively, nothing really has changed. Additionally, it is likely that the long-term interest rate has declined to a low level because the BOJ has to buy long-term JGBs from the private sector at high prices in order to expand the BOJ balance sheet. Nevertheless, because the long-term interest rate has little room to decline, so long as the BOJ only purchases long-term JGBs from the private sector, expanding its balance sheet will some juncture become hard (this would not be the case if the BOJ bankrolls government spending, as will be pointed out later).
Scenario 2: Financial repression (40% probability)
Even if monetary easing has reached its limits, it is still possible to escape from deflation if the government’s expansionary spending, financed by the BOJ, were to continue. Following the huge stimulus package that was Abe’s extra budget for FY 2012, it is virtually certain that, as we long feared would happen, another round of similarly massive spending will be adopted this year to cushion the economy against fallout from next April’s consumption tax hike (5% to 8%). And this whole process is sure to be repeated in the year after that for the same reason, as the second stage of the consumption tax hike (8% to 10%) is slated for October 2015. What this means is that the economy should continue expanding well above its trend growth rate (roughly 0.3%), fostering improvements in the output gap that bring about full employment at which point both wages and inflation will start rising. Even if it is impossible to achieve 2% inflation within two years (i.e., by early 2015), the end of deflation could come in sight from around the middle of 2015, when the economy’s continued outperformance could push the jobless rate below 3.5%, which is deemed full employment.
Even with Japan’s deeply engrained deflationary expectations, the end of deflation should come into sight if, after passing the critical point of full employment, the economy continues to outperform on the back of expansionary fiscal spending bankrolled by the BOJ. Meanwhile, the stoking of aggregate demand here is not due to monetary easing but the increased spending from fiscal expansion. What is more, this fiscal spending is responsible for expanding not only base money but also the more broadly defined money stock, and the BOJ’s role is only that of financing. Thus, in creating money and inflation, monetary policy is strictly an accessory to fiscal policy.
But when deflation is overcome, the long-term interest rate will become the next big problem. Since Japan’s equilibrium real interest rate is estimated to be about 1%, the long-term rate, after 2% inflation is realized, should climb to at least 3%, or 4-5% if risk premia is added. Given the fact that Japan’s public debt has swollen to 200% of GDP, a jump in the long-term rate could dramatically increase Japan’s odds of fiscal collapse. Thus, after successfully defeating deflation, the BOJ and government will have to shift their main focus to stabilizing the long-term rate in order to stave off a fiscal crisis.
What this means is that, even after deflation ends, the BOJ will probably have to maintain its zero-rate stance and aggressive JGB-buying. It is also possible that the BOJ could impose a tacit ceiling on interest rates by adopting policies to stabilize bond yields like the Fed’s “pegging operations” of the 1940s. If the BOJ were to opt for such interest rate caps, it would probably do so when the long-term rate climbs over 2%, as an interest rate in the 3% range could trigger a vicious cycle of financial system turmoil and fiscal chaos. This scenario of financial repression has a probability of 40% and is our main scenario.
It goes without saying that policies to hold the long-term rate down despite rising inflation essentially create negative real interest rates, allowing the public debt to be shrunk via a stealthy inflation tax on depositors. According to our estimates, if the long-term interest rate is kept at 2%, stoking inflation to 4% — creating a negative real interest rate of ?2% — would make it possible to reduce the public debt (as share of GDP). Meanwhile, we do not see financial repression as being part of some grand design adopted wholesale by policymakers to tackle Japan’s belt problem. Rather, it will come about unintentionally from a series of firefighting policies adopted in response to problems created by rising interest rates.
Scenario 3: High inflation (probability 15%)
Historically, if we exclude default, there are three ways to theoretically reduce a nation’s public debt: (1) fiscal adjustments/austerity plans (tax hikes, spending cuts); (2) elevating trend growth (via structural reforms) to increase tax receipts; and (3) monetization (financial repression is a type of monetization). Normally, the proper method ought to be (1), but politicians in parliamentary democracies are loath to take this approach owing to the pain imposed on voters. Given the ruckus over hiking Japan’s consumption tax to 8%, the 20% level necessary to secure the primary balance surplus needed to prevent the public debt from snowballing is a nonstarter. Most politicians favor method (2), as they hope to grow their way out of problems. But elevating trend growth is not easy. Even with effective growth strategies, dramatic results do not come quickly.
Ultimately, policymakers resort to monetization to reduce the public debt. Now the problem is whether inflation can stay in the relatively moderate range of 4~5%, as envisaged in our main scenario. It is very uncertain if inflation can be managed, as the BOJ will be powerless to act because fiscal dominance will prevail once inflation revives. When the long-term interest rate starts surging, the BOJ will cope with this crisis by essentially abandoning its inflation target, though this will be cloaked under the guise of “flexible” inflation targeting. If funds start shifting overseas on abhorrence of the negative real interest rates at home, a vicious cycle of yen depreciation and accelerating inflation could continue. As a result, inflation could approach double-digit proportions. Confidence in the BOJ could collapse and long-term rate could skyrocket without strong controls on interest rates. Japan’s precarious fiscal condition would be a constant reality. This high inflation scenario has a probability of 15%.
Meanwhile, trend growth can be depressed by distorted resource allocations even under the moderate 4~5% inflation envisaged in our main scenario. And if inflation were to approach double digits, households and corporations would be all the more hard-pressed to know what to expect regarding future income and future returns on capital. Owing to such increased uncertainties, the allocation of income and resources could be even more distorted and trend growth could even more depressed. Seeing how growth these past 30 years has averaged only 0.6%, one wonders if Japanese society can tolerate even moderate inflation (though it would preferable to higher taxes). Double-digit inflation, however, could greatly destabilize both the economy and society. There would be complete coordination failure. And crisis conditions could engulf not only state finances but also the whole of society.
Scenario 4: Happy end to deflation (probability 10%)
We have repeatedly pointed out that monetary/fiscal stimulus do not create any lasting value added. Even when such stimulus has an impact, it only does so by cannibalizing future demand (monetary stimulus) and consuming future income (fiscal stimulus). Until recently, households and businesses curbed spending because prospects for growth were diminishing alongside the floundering trend growth rate from a shrinking work force. As a result, the output gap also deteriorated and trend growth weakened alongside falling prices. Some contend that trend growth has not declined and that aggregate demand is insufficient because of chronic deflation, arguing that if trend growth had weakened then inflation should result from the insufficient supply capacity. But such a view is mistaken, as it lacks dynamic sense. When an economy is saddled with structural problems and trend growth falls, it is entirely possible that deflationary pressures could mount on deteriorating aggregate demand because spending by households and businesses turned lackluster first.
Now If Abenomics’ growth strategies were to show dramatic success, allowing the trend growth to significantly revive, the resulting improved growth expectations could encourage households and businesses to increase spending, thereby fostering improvements in the output gap that bring an end to deflation. While ending deflation via revived trend growth would be a happy ending, the probability of this optimal scenario is just 10%.
We cannot assign a higher probability because growth strategies, even if successful, do not bring dramatic changes. Currently, the government hopes to achieve trend growth of 2% over the coming decade, but that means the per capita trend growth rate will have to climb to 2.7%. Over the past 30 years, the only time per capita trend growth ever approached 3% was during the bubble in the latter half of the 1980s. If we assume that the workforce will continue shrinking almost 0.7% annually (and this figure prices in higher employment rates for women), increasing the per capita trend growth rate from the current 1% to 1.5% will still put overall trend growth at just 0.8%. Seeing how the per capita trend growth rate in America is slightly over 1% and that of the EU about 0.5%, hoping for 1.5% would be very optimistic. The government, however, aims for an even higher target (2.7%) and there is no magic wand to achieve it.
Now even if this happy ending scenario were to unfold, that does not mean that structural problems, like the swelling public debt and insolvent social welfare, will be headed for resolution. Of course, enhanced trend growth and positive inflation will provide big support for undertaking needed fiscal and social welfare reforms. But the happy ending alone cannot resolve Japan’s problems. The biggest reason for Japan’s ballooning public debt is that social welfare is chronically in the red because elderly on the receiving end continuing to swell in number (graying of society), while the productive population on the paying end steadily shrinks. What is more, with the debt having reached 200% of GDP, Japan’s fiscal health is very vulnerable to a rise in interest rates whatever the cause. As a result, even if the happy ending scenario unfolds, the government must still produce a credible plan for fiscal restructuring (including social welfare reform) and the BOJ will still have to maintain its zero-rate stance and aggressive JGB buying with an eye to curbing the government’s interest payment burdens.
Nominal wages in Japan lost downward rigidity after Japan’s 1997 financial crisis. In the years since then, wages have become downwardly flexible and upwardly rigid. As a result, even during corporate earnings recoveries, like today, labor might enjoy increased discretionary pay like bonuses but basic wages (scheduled cash earnings) have been held to very limited gains. Additionally, even when there are modest increases in the salaries paid to regular employees it does not easily translate into improved wages on a macro basis because the share of regular employees in the workforce continues to steadily trend lower. Without a revival in wages and service prices, inflation might momentarily rise on the back of yen depreciation but there will be no escape from deflation.