This article was first published as an op-ed in Nikkei Asia on August 8, 2023.


Loose stance still makes sense for now, but central bank must be ready to pivot

Inflation has made a comeback in Japan.

This year, the country has seen its consumer price index go as high as 4.3%, a level unseen for three decades. In most countries, inflation is not widely embraced, but in Japan, rising prices represent a milestone in breaking free from prolonged deflation.

The notion is that rising CPI can be a sign of a more vibrant economy, characterized by greater spending and demand. That in turn could serve as an indication of a transition toward a more sustainable and resilient growth path.

That said, accelerating inflation also poses a significant challenge for Bank of Japan policy formulation. The central bank must carefully navigate a delicate balance between stimulating economic growth and ensuring price stability.

On July 28, the BOJ took a small but significant step back from its ultra-easy monetary policy stance, relaxing the bounds on its purchases of Japanese government bonds. The central bank made clear, though, that its focus will remain unchanged until it can be assured that prices are growing around 2% a year in a stable and sustainable manner.

Japan’s core CPI rate, which excludes fresh food prices, has surpassed the bank’s target level since April 2022. Yet the BOJ continues to exercise caution regarding the benefits and costs associated with adjusting its current policy parameters.

Its gradual approach stems from uncertainties surrounding the future inflation outlook. In the view of the ASEAN+3 Macroeconomic Research Office (AMRO), Japan’s core CPI rate, which fell in June for the first time in 17 months to 4.2%, is peaking and will likely average around 3% this year and 2% next year.

Given the uncertainties around Japan’s inflation dynamics, however, the BOJ is right to maintain a cautious approach. Yet at the same time, the bank needs to be prepared to take a different position if signs of enduring high inflation emerge.

Due to heightened global energy and food prices, Japan’s inflation rate began to significantly accelerate during the second quarter of 2022, later than other advanced economies. A sharp depreciation in the value of the yen against the dollar then amplified the increase in imported prices.

Since late 2022, there has been another notable shift in the inflation landscape. Global oil prices have fallen while the yen has remained relatively stable after coming off lows unseen for decades. As a result, there has been a sharp decline in imported prices in Japan.

Yet underlying inflation has gained momentum in Japan this year, mainly due to price increases for goods and services unrelated to energy. It is not unusual for such price rises to take time to trickle through an economy though. Indeed, AMRO estimates that a 10% depreciation in the yen can take up to nine months to feed through into higher consumer prices.

Several pivotal factors could have significant implications on the entrenchment of sustained higher inflation in Japan.

First, the trend in wage growth will play a crucial role. This year’s spring wage negotiations showed signs that wages, which have been stagnant for decades, may finally be on the rise.

Major companies implemented a substantial 3.9% increase in wages, the biggest pay hike in 31 years. This signals employers’ recognition of the need to address employees’ rising cost of living.

Unfortunately, there is little reason for confidence that this year’s significant wage increase will carry over into next year or the year after, leaving open the question of whether rising pay will become an entrenched driver of higher inflation.

The pass-through of Japanese companies’ input costs will be another important factor in the inflation picture.

Japanese businesses, particularly those in the service sector, have traditionally been hesitant to raise prices for consumers.

Recently though, more have been passing along the impact of higher raw material costs and wages to customers. In April, Japanese prices for services rose 1.7% year-on-year, the highest monthly increase since 1995, excluding two periods when prices were affected by consumption tax hikes.

The current higher inflation environment may give Japanese companies a stronger push to raise prices to cover their costs, posing an upside risk to the inflation outlook.

Lastly, inflation spikes driven by supply-side factors must be taken into account, although such effects tend to be temporary.

The impact of higher imported prices on domestic inflation and inflation expectations should be monitored. Ongoing geopolitical tensions can potentially cause temporary supply disruptions and could lead to another spike in energy prices. Additionally, given the sustained monetary policy divergence between the U.S. and Japan, recurrent and rapid depreciation of the yen could further accelerate domestic inflation.

Considering the substantial uncertainties surrounding Japan’s inflation dynamics, it is essential for the BOJ to be prepared for the potential emergence of a post-pandemic “new normal” characterized by an enduring higher inflation environment.

Taking a longer-term perspective and considering uncertainties with the global economy, it is indeed prudent that the BOJ has embarked on a comprehensive review of its monetary policy framework.

With the experience of the past decade in mind, there is a need for the BOJ to explore options for greater flexibility on the back of clearer communication of its policy adjustments. Specifically, the BOJ could consider acknowledging that its longstanding target of 2% inflation may not be aligned with underlying price-setting behaviors in the country.

As a more practical and realistic goal, the BOJ could consider adopting a price stability target band of 1% to 3%. This would provide the central bank with more flexibility in conducting monetary policy. Given continued instability in the global environment, the BOJ needs to be adaptable.