Japan: Inflation Irony

The October core CPI rate returned to positive territory for the first time since last December, owing to a stronger contribution from energy-related products. An unexpected rise in the core-of-core effectively for the first time since 1999 was also important news. Going forward, we expect the November core CPI rate to surge at least to +0.3% YoY, given the higher contribution by energy-related prices. Further, it is likely to rise to +0.6-0.7% YoY during the Jan-Mar quarter next year. In short, the long-awaited inflation is now coming back. Does this mean an end to deflation? We don’t think so.

First, wages remain sluggish and the unit labor cost is dropping with a wider margin, given the virtually flat nominal employees compensation and moderate rebound of the real GDP. Second, despite the surge in some domestic demand component deflators such as capex, housing and public investment, the GDP deflator, which is another proxy of income, remains sluggish due to a higher import deflator. Third, the revised CGPI statistics have revealed that the domestic final consumer goods prices, on which we focus for correlation with the CPI, were revised down from 0% YoY to -0.7% for the Jul-Sept average. Using the new base year, domestic final consumer goods prices have been falling YoY since January 2006, highlighting the extremely slow pace of price shift to final consumer goods. Also, per our estimates, domestic final goods prices including capital goods have been down continuously YoY since December 1992.

Going forward, our concern is the squeeze of real income by higher prices. In the January-March quarter, nominal wages should display slow growth while consumer prices are likely to rise more quickly. Thus, the extent of the drop in real disposable income should widen. Some employment-related indices are likely to turn down, owing to deterioration in the profit margins at small to medium-sized companies, and we forecast a negative wealth effect stemming from yen appreciation and lackluster share prices. As a result, personal consumption will probably be unspectacular in the January-March quarter.

Also, the employment situation is cause for concern. Although appetite for employment appears to be strong at large manufacturers, the employment environment seems to be deteriorating at SMEs in particular. Grass roots sentiment as indicated in the Watchers Survey has been weakening constantly in the past six months, suggesting a possible spread of bearish SME sentiment to employment. We are yet to see noticeable changes to the employment conditions of the construction industry, which is suffering from a sharp decline in construction starts; however, we think that the revised Building Standards Law could boost the number of bankruptcies at related SMEs. One of the things to watch going forward will be whether the December Tankan (due out on December 14) will reveal signs of modulation in the employment DI for SMEs.

For policy implications, with the shock waves from the subprime issue extending their reach, and time running out for the current BoJ leadership, we have to conclude that the possibility of a rate hike before the end of F3/08 has diminished substantially. Indeed, we expect the October-December GDP data due out in mid-February to point to a muted tone as a result of the amended Building Standards Law, and think that this all but rules out the prospect of a rate hike being agreed at the MPM in either February (14-15) or March (6-7). Moreover, with the Democratic Party – which effectively has the power of veto over choices at the top of the BoJ – insisting that the issue must be deferred to the next Administration after the general election, a general election taking place at around the same time as the terms run out on March 19 could have the effect of creating a vacuum – if only temporary – in the positions of governor and deputy governors. Alternatively, it is possible that the government might find itself having to deal with the situation by keeping current incumbents in place for a provisional period. If so, it seems common sense to assume that there would be no change in policy under such a provisional leadership, and that the prospect of a rate hike at the next MPMs in April (8-9, 30) and May (19-20) would be low as well.

Based on these considerations, we have put back our estimate of the timing of the next rate hike to July-September 2008 or later, though there is a risk that the slippage could be even more protracted. Alternatively, if a risk scenario were to emerge in which the US economy entered into recession and share prices fell even more steeply while the yen appreciated still more sharply, the BoJ would probably feel the need to start considering monetary easing. A rate cut is not part of our main scenario at the moment, but depending on how the market climate pans out, it is possible that the market itself would start factoring for such a scenario. Indeed, it is ironic if the BoJ has to consider the monetary accommodation in the midst of the long-awaited recovery of the CPI rate.

By Takehiro Sato Tokyo
Morgan Stanley
December 10, 2007