Japan has always been regarded as different from other countries. Beginning in the early 1990s, it experienced decades of prolonged deflation and zero interest rates. Now, it is considering an interest rate hike when other countries are preparing to cut rates.
Of course, the background is a prolonged and substantial currency depreciation. Interestingly, the situation is not bad, as the stock market is seeing a historical high. Yet if the economy is back, we should see Japan experiencing high inflation, but both the market and policymaker Bank of Japan (BoJ) do not regard the nation’s inflation as being high.
Cyclically speaking, we should not focus on the level of growth but on the direction instead. For an aged country such as Japan, real growth and inflation are bound to be low, which is normal. But this is structural rather than cyclical. Removing the trend components of these variables would still exhibit cyclical movements due to global and specific shocks. Although the detrending can be done via a statistical filter, a simple measure, such as year-over-year growth, may already capture such a cyclical component, given the growth of the trend component is minimal.
The accompanying chart presents the year-over-year growth of the two key variables, namely, gross domestic product (GDP) and consumer price index (CPI), which refer to the real quantity and nominal price, respectively. Usually, when a country is not subject to adverse supply shocks such as during a pandemic or war, demand shocks should result in a positive correlation between the two—imagine the equilibrium locus (over time) under the shift of the demand curve. This is, in fact, true in Japan if we take into account that CPI is lagging, where the two lines, by and large, comove along the same direction, with CPI lagging by a year.
Given this relationship of a 1.5 percent change in GDP growth resulting in a 1 percent change in CPI growth, there were times when inflation was “under” and times when it was “over.” In the early 2000s, inflation was lower than supposed (with respect to economic growth), while in recent years, it was higher. These breaks in correlation are interesting and deserve an explanation.
The “under” of inflation in the 2000s is well-known to be a debt deflation phenomenon. However, the “over” of it in recent years has been overlooked by many analysts. The real side of the economy is clearly not so outstanding, as shown by the unsustainable GDP growth. Accordingly, inflation should have come down as projected, but it did not. Adverse supply shocks due to COVID-19 and geopolitical tensions were indeed causes but have mostly faded out by now. Then, by elimination, the remaining cause is most likely the abuse of monetary easing.
Prolonged negative real interest rates and exchange rate depreciation are common reasons for high inflation. Again, Japan’s latest inflation is not high compared to other countries but certainly not low with respect to its GDP growth. This suggests that after its mistake of easing too late in the early 1990s, the BoJ is probably committing another mistake of tightening too late now.
The abnormality seems a result of mostly policy mistakes rather than an exceptional economy.
