April 28, 2014 7:00 pm JST

Frederic Neumann : Bank of Japan too optimistic on inflation


On the face of it, it was a victory for Japan's central bank. Core inflation in Tokyo jumped an annual 2.7% in April, the fastest pace since 1992. Not bad for an economy gripped by deflation for well over a decade. The Bank of Japan unveiled its most ambitious easing program yet last year, with a promise to double the monetary base and slay deflation for good. Look closely, however, and it's not clear that price pressures have really risen as much as the headline number suggests.

     That matters. If it appears inflation may fail to reach a sustainable 2% by next summer, officials will need to reload their cannons and deliver another round of monetary stimulus. That would take the central bank even further into uncharted territory, with its balance sheet already far more bloated than that of other major central banks, including those in the U.S. and Europe. The impact would be felt well beyond Japan, affecting currency markets and possibly pushing even more liquidity into neighboring economies that have already begun to see inflows rise thanks to last year's easing by the BOJ.

Not so different, after all     

What, then, of inflation? The price jump in Tokyo, watched by investors because it closely reflects price trends across the nation, can be explained entirely by the April 1 increase in the sales tax. According to the central bank's own calculations, this added 1.7 percentage points to the headline reading, which means that, without it, prices would have risen only 1% over the year, exactly the same as during the previous month. Not quite so impressive.

     What's more: One might have expected at least a slight increase in underlying inflation given that the tax hike provided convenient cover for anyone itching to lift prices more than warranted by the tax increase alone. The fact that underlying inflation remained unchanged thus suggests that companies still have little faith in their pricing power.

     But there are other reasons to suspect price pressures aren't quite as forceful as officials would like. The hefty depreciation of the yen between late 2012 and mid-2013 evidently raised the price of imports, pushing up inflation. However, since then, the currency has stabilized. As inflation commonly measures price increases over the course of a year, the effect of the tumbling yen will quickly fade. In fact, this is already beginning to happen. National core inflation was unchanged at 1.3% between December and March. To push inflation up, the yen may have to weaken further, but that seems unlikely for now unless the central bank again delivers another round of aggressive easing.

     Fundamentally, what drives inflation over time is not tax hikes or volatile exchange rates but economic growth. Here, too, the outlook is not quite as rosy as officials seem to expect. What has fueled the economic rebound over the past year is primarily a jump in household and fiscal spending. These, however, look harder to sustain.

     Rising inflation, even if not quite at the pace desired by the central bank, undermines the purchasing power of consumers. Wage growth, despite much prodding by the government, hasn't accelerated enough to offset the increase in prices, especially in light of the latest tax hike. As Japan's household savings rate is already razor thin -- at an estimated 0.6%, among the lowest in advanced economies --  consumption may not hold up as well as expected.

Long way to go     

Room for additional fiscal spending also seems limited. With debt piling up, and already two generous stimulus packages under its belt, the government will need to tread carefully. In fact, another sales tax hike is already scheduled for October 2015, even if Prime Minister Shinzo Abe has said that a final decision on its implementation won't be made until the end of this year. Financial markets, and the central bank for that matter, will likely push for continued fiscal consolidation.

     The big hope, then, is that exports will boost growth. In principle, the tumble in the yen should have raised the competitiveness of Japanese companies. Profits of exporters have certainly soared over the past year. However, this hasn't yet translated into a convincing increase in shipments. In March, exports contracted by more than 3% over the month, and Japan's trade deficit reached a record high over the past fiscal year. Faster growth in the West, it seems, is being offset by slowing demand in China and other emerging markets that have become important for Japan.

     With price pressures failing to pick up sustainably, it seems likely that the central bank will need to throw another log onto the fire. Officials are fully committed to raising inflation to 2% over time. To be sure, prices so far have climbed faster than many expected at the beginning of last year. But temporary factors are mostly responsible for this. Don't be fooled by the headlines: Japan is still a long way from beating deflation for good.

Frederic Neumann is co-head of Asian economic research at HSBC.