Inflation returns to Japan

Japan’s public finances rest on borrowing large sums of money at an interest rate around zero. As Now inflation and wage rises have finally returned can the central bank cope?

| 7 min read

Japan has a Prime Minister who would like to be more popular. His own popularity and that of his government stands around 35%.

There is a continuing overhang from the events surrounding former Prime Minister Shinzo Abe’s assassination. The introduction of a personal number for every citizen went badly and the decision to release water from the damaged Fukushima nuclear plant has many critics. People are not enjoying the higher inflation Japan has worked hard to create.

Prime Minister Fumio Kishida has just reshuffled his cabinet – promoting more women – though there was no poll boost as a result. He is planning another stimulus. Briefings tell us he will extend help with utility and fuel bills for longer.

Japan has new problems and opportunities, as policy has at last awakened inflation after an absence for more than twenty years. Many in Japan are pleased they now have some wage inflation. The government wants wages to go up by more than prices, so people enjoy a real rise. There is much discussion about how they could sustain the idea of annual wage rises after a long period when many employees accepted base wage rates stayed the same and the only way to earn more was to be promoted.

There is some tension between the central bank and the government. Whilst there is general pleasure about wage rises this spring, there is unhappiness that price rises have eroded them. Attention is turning at the central bank – as well as in the cabinet – to the issue of securing real wage rises.

Tensions between government and central bank

The government blames the Bank of Japan for letting price inflation get above the 2% target after many years of shortfalls. There are also worries about the weakness of the yen, which has added to inflation for imported goods. The central bank is more worried that the rise in inflation they wanted could turn out to be temporary. If inflation subsides as they think, could wage growth end as well?

The decision to add another stimulatory package continues what governments have been doing for a long time in Japan. Offered as much borrowing as they would like at zero interest rates, government has got used to plenty of spending. In November 2021 there was a stimulus package of $490bn, in October 2022 $200bn and today media briefings suggest they are planning a more modest $70bn. They have tried capital investments in infrastructure and subsidies or low taxes to stimulate spending. Japan with its ageing society has continued to save and has been reluctant to expand its spending, particularly if that entails more personal debt.

Japan’s public finances rest on borrowing large sums of money at an interest rate of around zero. Despite the very low interest rate, debt service is 22% of the current year budget, a percentage kept down in recent years by low interest rates despite a surge in new debt. This year, bond issues will pay for 31% of the total spending, with only 69% covered by tax revenues.

The problem with this model, which has proved stable for many years, is what happens if interest rates rise and stay up? The central bank – and the state which supports it – will lose large sums on their big bond holdings, and the Treasury will need to rein in other spending and increase taxes to reduce the amount of additional borrowing they need to undertake to sustain elevated spending levels. The treasury openly worries about the large amount of spending on social security.

The central bank has been more adventurous of late

For many years the Bank ran large quantitative easing programmes, creating more money to buy up large quantities of Japanese government bonds and even adding in some exchange-traded funds tracking equities. It adopted a policy of yield curve control, making the ten-year government borrowing rate the crucial rate they wished to manage. It promised to keep this at zero, implying negative rates for shorter dates. It would buy as many bonds as it took to keep rates down to zero.

The central bank allowed itself 0.25% of leeway either way but regarded a ten-year interest rate of 0.25% as an absolute limit triggering unlimited purchases if market rates threatened to go higher. At the end of 2022, this became expensive and difficult to enforce, so it relaxed the band to 0.5% allowing rates to drift a bit higher. This year they have reworked the policy again, keeping the plus or minus 0.5% but saying they will only buy unlimited quantities of bonds should the market rate shoot up to 1.0%.

Members of the bank’s Monetary Policy Committee deny this means monetary tightening, though it looks a bit like a cautious version of it. They say the plan is still to keep monetary policy easy as they are not yet persuaded 2% inflation is here to stay or more importantly that wage rises every year will embed as normal practice after years of absence. The prime minister and the Bank of Japan agreed on his new capitalism, where they established” a virtuous cycle of growth and distribution, with sustained wage gains that outpace prices”. It may not be as smooth and easy as they hope.

Market expectations assume rates will stay low, inflation will not take off and Japan will muddle through.

There are risks in these strategies. The Japanese seem most afraid that the inflation will subside later this year and they will miss out on the chance to create what they think is a benign series of wage rounds where wage increases translate into real gains and more consumer spending. Others will worry that they might indeed succeed in embedding some inflation and that might prove more obstinate and less benign than they think. It could continue to be the kind of inflation that hits consumers and frustrates real wage growth producing rising living standards.

The worst risk of all is that if it unleashed more inflation it could end up with the need to hike interest rates much higher. The central bank and the Japanese state would be faced with harsh choices if they need to pay a more normal rate of interest on past debts and rein in future borrowings. Japan’s state debts have risen from 368 trillion yen in 2000 to 1068 trillion in 2023. State debt to GDP has soared from 59% in 1990 to 258% today.

Market expectations assume rates will stay low, inflation will not take off and Japan will muddle through. It will be necessary to watch wages and wider price behaviour from here now that inflation has stirred – even in Japan.

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Inflation returns to Japan

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