While the market is anticipating and central banks are planning to slow down the pace of monetary tightening, there are signs of inflation rebounding in Australia and the U.S. (the core month-over-month inflation accelerated recently). Japan is the only advanced economy doing nothing in the face of such a trend. Japan’s inflation change over the past two years was not small: it moved from -1.2 percent at the end-2020 to +4.0 percent at the end-2022—a more than five percent increase broadly comparable to the rest of the G6.
Bank of Japan (BoJ) has been betting on a downtrend. Is this a good bet? It depends heavily on the source of the inflationary pressure. At best, the shock can be decomposed into common (global) versus specific (local) components, but this involves conjecture of what causes inflation within Japan and what causes inflation outside. However, without having a complete inflation cycle (the down part has still not yet been realized), such conjecture runs a high risk of being wrong.
Intuitively, supply shock transmits to inflation much more quickly than demand does. Recall the shortage of COVID or war-related materials pushed up prices quickly, but stimulative policy restored confidence slowly. The sharp fall of international commodity prices suggests supply shortage should no longer be an issue now, nor should the logistics, evidenced by the subdued Baltic Dry Index. To date, the supply side argument should have been eliminated, leaving the demand side and excess money arguments remaining.
For monetary easing to have a real effect , we should have observed wage growth. Imagine you are a boss facing stronger demand; you will first pay higher to recruit more staff. This is especially true in services-dominated advanced economies like Japan. The attached chart shows total cash earnings growth commoving with price inflation. The former has no predictive power to the latter for their synchronous relationship, but whether wage or price inflation, the common source is still the accommodative policy.
As we discussed previously, monetary expansion usually leads prices by 1.5 to 2 years. Previous monetary expansions were ineffective because the monetary base (MB) did not augment broad money (M3), or the multiplier effect was very low. This time M3 grew strongly but did not last for too long. Even without hiking interest rates, MB is now shrinking year-over-year, which suggests there has been de facto tightening. Based on the past relationship between broad money and wage/price growth, BoJ bets inflation would come down soon.
This line of argument, in principle, makes sense, but empirically inflation can only come down with delay or very slowly. Modern academics tend to believe that the wage-price spiral, where price inflation was fuelled by overheated employment, is solid and hard to tackle. This is exactly the situation faced by the rest G6, rendering Japan not immune from the inflationary trap.
