On Wednesday (July 12), the Financial Times published a guest column by me on the yen’s weakness. The recent gyrations of the yen show how much, and how quickly, its value depends on changes in the interest rate gap between US and Japanese 10-year bond yields. When I wrote the column, that gap was rising, and, as a result, the yen was weakening so fast that the Japanese Finance Ministry was threatening intervention to shore it up. By the time it was published, three news events caused the rate gap to narrow, which, in turn, caused the yen to regain some of its lost value (see chart updated from the one published in the FT).

Source: Ministry of Finance, Federal Reserve Board

            In the US, weaker-than-expected jobs growth and a bigger-than-expected decline in inflation led the market to expect that the Federal Reserve would not raise interest rates as much as the market previously expected. That changed anticipation led to a fall in the 10-year Treasury bond. In Japan, a misreading of the May wage figures led to expectation by some players that the Bank of Japan might let interest rates rise sooner than previously expected, perhaps as early as its meeting this month. I’m not a professional forecaster, but I’d be surprised if the BOJ moved that quickly.

            Here’s the text of the FT column. For those with a subscription, click here.

Intervention to shore up the yen will not work

Japan’s currency is so weak because exporters have lost their competitiveness.

The yen has weakened so much that, once again, Japan’s ministry of finance is threatening to intervene in currency markets to shore up its value. If it does so, it is bound to fail, just as it failed last year despite spending a stupendous ¥9.19tn, almost 2 per cent of gross domestic product.

Intervention only works when a currency is out of line with economic fundamentals, but that is not the case today. The yen is so weak — worth 25 per cent less than two years ago — because Japan’s exporters have lost their past competitiveness. In fact, if current trends continue, Japan may be overtaken by Korea in the real (price-adjusted) volume of exports.

A few decades back, Japan’s consumer electronics, industrial machinery and automobiles were so clearly superior that its exporters could command high prices and still enjoy a high share of global exports. Today, however, these companies have shed much of their lustre. To sell their products, they must lower their prices, which requires a weaker yen.

In fact, the “real effective yen” is the weakest it has been in a half-century, according to the Bank of Japan. That measure takes into account the difference in price trends between Japan and all its trading partners. As a result, the real effective yen indicates how the prices of Japanese products in foreign markets compare with those of competitors.

Over the past two years, the main factor in the yen’s value has been the gap between 10-year government bond rates in the US and Japan. When Treasuries pay much more than Japanese government bonds, investors sell the latter and therefore the yen itself, in order to buy dollars as they purchase US debt. That selling pressure lowers the value of the yen.

In fact, since July 2021, there has been a stunningly high 97 per cent correlation between daily ups and downs in the rate gap and daily moves in the yen-dollar rate. The MoF intervention last autumn could not alter this linkage, nor would it today. At present, the interest rate gap is fluctuating around 3.5 per cent and a yen that recently weakened to ¥145 a dollar is in line with that gap.

If the interest rate gap were the sole cause of the weak yen, then a rise in Japanese bond rates and a fall in US rates could cure the problem. In reality, the yen is not likely to return to levels deemed normal a decade or two ago. On the contrary, an interest rate gap that yielded a ¥100 per dollar exchange rate back in the early 2000s now translates into around ¥120 per dollar.

The reason is that, even with a cheap yen, Japanese companies have trouble competing with exports. For the 30 years to 2010, whether the yen was strong or weak, Japan ran trade surpluses every year but one. Since 2011, however, the country has suffered trade deficits in nine of the past 12 years, even though the real effective yen during the last decade was 25 per cent cheaper than it was during 1980-2010. While in the short-term, income from Japan’s foreign investments acts as a counter to weakness, the longer-term direction of the yen must reflect the trade weakness. 

Japan’s share of price-adjusted exports by rich countries peaked at 8 per cent back in 1985. Over the succeeding decades, the share steadily dropped to just 5.8 per cent, despite the steady weakening of the yen. By contrast, both the US and Germany maintained their share.

In 2000, Japan’s electronics companies enjoyed a trade surplus equal to a hefty 1.3 per cent of gross domestic product; now the sector regularly runs trade deficits. In autos, Japan will soon be overtaken by China as the world’s top exporter, partly because Japanese companies lag in battery-powered electric vehicles.

The auto case brings up another reason a weak yen has not helped Japan’s exports as much as policymakers had hoped. Japan’s carmakers make more than 80 per cent of their overseas sales by producing overseas rather than exporting from Japan. The same pattern is seen in electronics, machinery and other products. The more Japanese companies move their production overseas, the smaller the boost to exports for any given drop in the value of the yen.

One final point: a weak yen means Japanese households and producers have to pay more for foodstuffs and energy. And it leaves consumers with less money to buy products made in the country. As a result, real (price-adjusted) household spending in 2023 is no higher than it was way back in 2012. The weak yen doesn’t just reflect economic weakness; it also makes a weak economy even shakier.

The writer is the publisher of Japan Economy Watch and author of the forthcoming book ‘The Contest for Japan’s Economic Future’

Copyright The Financial Times Limited 2023. All rights reserved.

Source: https://www.mhlw.go.jp/english/database/db-l/monthly-labour.html

The headlines were celebratory: in May, Japanese workers enjoyed the fastest growth in nominal wages in 28 years: 1.8% compared to the year before. Of course, the articles went on to note that “enjoyment” may be a little strong since workers suffered the 14th consecutive month of decline in real, i.e., after-inflation, wages. As fast as wages grew, they still lagged behind rising prices (see chart below).

            Still, the growth in nominal wages was deemed a victory on the way to achieving the Bank of Japan’s goal of a sustained 3% annual growth in nominal wages, which it says is necessary to achieving sustainable 2% inflation. So, many of the articles focused on what the wage data meant for BOJ policy.

            The problem is that the article writers failed to let their readers know a simple but salient fact: the data they were citing reported nominal wages per month, not per hour. And the main reason regular wages (not counting overtime or bonuses) rose 1.8% during May was not a pay hike, but the simple fact that scheduled hours of work rose even more: 2.0% (see chart at the top). Consequently, wages per hour did not grow 1.8% as the articles implied; on the contrary, they fell 0.2% (see chart below). You can bet that BOJ policymakers know the difference.

            Yet, so many of these articles either stated, or implied, that the 1.8% was the result of pay hikes agreed to in this year’s shunto wage talks between big companies and their unions. In reality, such talks only cover a small sliver of the workforce, and it remains to be seen how the majority of workers will fare. But the news over the past two months has not been encouraging. For example,  a quarter of small and medium-sized businesses—who employ about 70% of all workers—did not raise hourly wages at all, according to Tokyo Shoko Research.

            It seems hard to believe that none of these article writers, or their editors, were aware of the link between wages paid and hours worked. After all, the Labor Ministry’s website is quite clear. It listed the monthly wage for scheduled hours at ¥252,132 ($1,775) for workers at firms with at least five employees and then showed it was this figure that increased 1.8% from the year earlier, while another table on the site showed that hours increased 2.0%.

            Why, then, did they choose not to mention it? Were they too focused on what this might mean for BOJ interest rate policy? Did they simply not think too deeply in reaction to the fact that the rise was twice as big as the consensus forecast? Was there bandwagon effect?

            It is still possible that nominal wages will show an acceleration from the past few years. As the charts show, hours and wages fluctuate a lot from month to month. But, if June and July figures show no significant wage hike per hour from the year before—adding up to four months since April when the wage hikes first showed up—this celebration will have proved not just premature but wrong. Whatever the newspapers may say, officials at the BOJ are being more cautious. Their policymaking for now is data-driven, and the data are far too ambiguous to spark a change in BOJ policy.

Nominal vs. Real Wages

Why are market players focusing on nominal wages rather than real wages? After all, the latter count more for living standards and consumer purchasing power. The reason is that the BOJ is watching nominal wages. It believes that if nominal wages rise at a sustained 3% per year, then consumer inflation will rise to a sustained 2%, which is its goal. In that case, it can let interest rates rise, which has a lot of significance for financial markets as well as the real economy.

            The BOJ theory is that if wages rise by 3%, and productivity (output per work hour) grows at 1%, then business employment costs will rise by 2%, i.e., 3% minus 1%. It figures companies will be able to pass this cost onto consumers. The chain of logic is as follows: if wages rise 3% per year, then the BOJ can let interest rates rise to bring inflation down to 2%, but businesses will keep raising wages by 3% per year.

            There are a lot of assumptions in this theory. One is the presumption that businesses will be willing to hike real wages. Yet, for years, Japanese companies have refused to raise wages even though they could afford to do so. Secondly, it also assumes that inflation is caused by an increase in business costs, even if there is no increase in economic demand led by rising real consumer purchasing power. Is this true? Here’s what we know.

            Japan’s real wages per month have been falling for years and, as of May 2023, are 12% below their level back in 2007 (see chart below).

            Keep in mind that this fall includes the impact of cuts in hours worked per month, cuts in bonuses and overtime, a shift from higher-paid regular workers to lower-paid non-regulars, and the consumption tax hikes of 2014 and 2019.

            The impact of lower real wages on consumer spending is very substantial. Consumers kept up spending for a while, despite declining real wages, by cutting their savings rate. But now the savings rate is so low that this measure has run out of steam. As of early 2023, total spending by all consumers, wage-earners, and retirees alike was no higher than it had been back in 2012, more than a decade ago (see chart below).

Source: https://www.esri.cao.go.jp/jp/sna/data/data_list/sokuhou/files/2023/qe231_2/tables/gaku-jk2312.csv

            The BOJ has a history of bad theories: e.g., its promise back in 2013 that it could reach 2% inflation in just two years based on an unrealistic theory popular in academia called “rational expectations.” BOJ staffers now readily admit the theory did not work. Time will tell whether this is yet another bad theory.

Source: https://www.federalreserve.gov/releases/h10/hist/dat00_ja.htm, https://www.federalreserve.gov/datadownload/Choose.aspx?rel=H15, and https://www.wsj.com/market-data/quotes/bond/BX/TMBMKJP-10Y

As I write this, the yen stands at ¥143.8/$. That’s the weakest it has been since November 19^th, about a month before the Bank of Japan (BOJ) “tweaked” its interest rate policy to allow 10-year Japan Government Bonds to rise to a maximum of 0.5%. Following that move, which the market misinterpreted as the first of many hikes in interest rates, the yen strengthened to ¥127 in January. Many forecasters projected it could continue to strengthen. Instead, it started steadily creeping back upwards.

            As we’ve repeatedly stated, over the past two years, the ¥/$ rate has closely tracked the gap between Japanese and American 10-year government bond rates, with a supremely high 97% correlation. The bigger the gap, the weaker the yen (see chart at the top). Earlier in the year, many market players believed that the gap would lessen as the BOJ raised interest rates and the Fed began cutting them toward year’s end. Now, far fewer market participants still believe that; so fewer are willing to buy the yen at prices as high as they were a few months ago. The decreased demand for the yen causes it to weaken.

Learning to Believe the Central Banks Mean What They Say

On the BOJ side, even though Governor Haruhiko Kuroda made it clear that the move on 10-year bond rates was just loosening a “steam valve,” a tactic aimed at enabling him to maintain the BOJ’s ultra-dovish policy, many in the market believed he would be forced to raise rates. Some even believed he intended to raise rates but did not want to say so. Then, when Kuroda finished his term and was replaced by Kazuo Ueda, the market view was that Ueda would move rates higher in response to higher-than-expected inflation. Many players did not believe him when he said that BOJ still saw today’s inflation as temporary, that sustainable inflation required 3% nominal wage hikes, and that lifting rates too soon was a worse mistake than lifting them too late. Now, they increasingly believe he means what he says and that he has the ability to sustain his policy until the picture becomes clearer.

            As for the Fed, many forecasters expected that the Fed’s campaign of raising would send the US into recession sometime this year and that, as a result, the Fed would have to start cutting rates again before the year ended. Instead, the US economy has proved surprisingly resilient in the face of higher interest rates and, as a result, Fed chair Jerome Powell told Congress this week that he foresees two more interest rate hikes this year. Unless the economy weakens, bringing inflation back down to the Fed’s goal of 2% will prove difficult.

            With the BOJ keeping rates low and the Fed raising them again, the US-Japan rate gap has rebounded. As it did so, the yen/$ rate weakened in tandem (see again chart at the top).

A Chronically Weak Yen

While the interest rate gap has been the single-biggest factor in the yen/$ rate in the short term, the more fundamental determinant has been the increasing loss of competitiveness on the part of many of Japan’s leading companies. As a result, it takes a weaker and weaker yen for Japanese companies to sustain exports.

            The best measure of the yen’s underlying value is the so-called “real yen,” which adjusts the yen’s nominal value for changes in inflation/deflation in Japan compared to other countries. That tells us the real purchasing power of the yen: how many cars or computer chips does Japan have to send to foreign buyers in order to pay for all the coal and wheat it imports? If it has to pay more in the form of cars or computer chips to buy the same amount of coal and wheat, it means the real yen is weaker because Japan’s exporters are less competitive than they used to be. According to this measure, Japan’s real yen is the weakest it has been since a half-century ago in the early 1970s (see chart below).

Source: https://www.stat-search.boj.or.jp/ssi/cgi-bin/famecgi2?cgi=$graphwnd_en

Note: The horizontal line at 100 is the 1970-2023 average. The bands at 80 and 120 show there the real yen has been about two-thirds of the time. It further illustrates how weak today’s yen is.

            The benefit of a weak currency is that it is supposed to help a country export more, while it imports fewer products that compete with domestic producers. This should boost domestic growth. So far, however, this has not proved to be the case. The real, i.e., price-adjusted, trade deficit is much higher than it was two years ago (see chart below).

Source: https://www.esri.cao.go.jp/jp/sna/data/data_list/sokuhou/files/2023/qe231_2/tables/gaku-jk2312.csv

At the same time, the nominal trade deficit has deteriorated to around 4% of GDP as of January-March (see chart below).

Source: https://www.esri.cao.go.jp/jp/sna/data/data_list/sokuhou/files/2023/qe231_2/tables/gaku-mk2312.csv 

In other words, Japan is paying higher prices for needed imports of raw materials, energy, foodstuffs, machinery, and assorted consumer goods. This is one of the major reasons for the rise in consumer inflation and the corresponding drop in real wages. In essence, the weak yen is transferring income from Japanese consumers to foreign producers as well as to Japanese exporters. Japanese households are paying a high price for little benefit.

Wither the Yen?

What does all this tell us about the future value of the yen? Back in 2001-13, when the interest rate gap between the US and Japan was 3%, it took just 110 yen to buy a dollar. Today, by contrast, when the rate gap is 3%, Japan has to pay around 130 yen to buy a dollar (see chart below). ). It looks like, no matter what happens with interest rates, the yen will remain a lot weaker than it was a couple decades ago—at least for a long while.

Source: https://www.federalreserve.gov/releases/h10/hist/dat00_ja.htm, https://www.federalreserve.gov/datadownload/Choose.aspx?rel=H15, and https://www.wsj.com/market-data/quotes/bond/BX/TMBMKJP-10Y

Source: https://www.mhlw.go.jp/english/database/db-l/monthly-labour.html

Wages failed their first test in April as to whether the much-ballyhooed wage hikes negotiated by leading companies in the spring would really result in a substantial rise for the labor force as a whole. Economists had expected that nominal monthly wages per worker would rise 2% from the year before, but they only rose 1% (see chart above). The 2% hike was expected because in the annual labor negotiations, known as the shunto, leading companies had agreed to an average 2.1% increase in base pay. (The much-reported headline number of 3.7% includes base pay plus the rate of increase workers get as their seniority rises; the latter does not create a rise for the labor force as a whole).

            Officials cautioned that the results won’t be fully known until May or June, because different companies implement their hikes for the year at different times.

            Still, there is no doubt that this was a disappointment. “While we must wait until May to see the full picture of the shunto results, April’s growth wasn’t as strong as expected,” Takeshi Minami, chief economist at Norinchukin Research Institute, told Reuters. That disappointment was amplified by a 3% drop in real wages, i.e., nominal wages minus inflation. The disappointment was also amplified by a 4.4% drop in nominal household spending in April. This was the second consecutive month of a year-on-year decline in consumption.

            These results will reinforce the reluctance of the Bank of Japan (BOJ) to let interest rates rise. As a result, the gap between Japanese and American rates will remain at a level that keeps the yen weak; at present the yen is around ¥139-140 per dollar.

            The BOJ says that it cannot change its monetary ease until it sees clear evidence that core consumer inflation is set to rise at a 2% annual rate on a sustained basis. For this to happen, says the BOJ, nominal wages must rise at a 3% rate. Given its expectation of 1% growth of labor productivity, a 3% nominal wage hike results in a 2% hike in labor costs to employers, a cost that the BOJ believes they would pass onto consumers. In the absence of such wage hikes, the BOJ expects the current high rate of inflation to drop below 2%.

            Critics say that the BOJ is underestimating the force and likely persistence of inflation, but, as discussed in a previous post, markets currently lack the power to force the BOJ’s hand.

Real Wages Continue to Drop

Japan’s drop in real wages is not a temporary result of its post-Covid bout of inflation but is a problem of years’ standing. Real monthly wages per worker had already fallen by almost 6% from 2010 through 2019 before Covid. Then, the post-Covid inflation caused them to fall even further (see chart below). Much of this was the result of the replacement of many full-time regular workers with lower-paid non-regulars, as well as the two hikes in the consumption tax (2014 and 2019). If the real wages prevailing during the first four months of 2023 continue throughout the year, then real wages this year will end up almost 10% below the 2010 level.

Naturally, falling income results in slack consumption. Total real employee compensation of all workers combined in the first quarter of 2023 was no higher than it had been in 2017. As a result, total real consumption in the first quarter of 2023 was 1.6% below its level in 2017 (see chart below).

Source: https://www.esri.cao.go.jp/en/sna/data/sokuhou/files/2023/qe231/gdemenuea.html

What To Look For In the Coming Months

Since many companies have not yet implemented the wage hikes negotiated in the spring, the Kishida administration and BOJ hope that May and June results will be better.

            Time will tell, but there are some other indicators, and they are not encouraging. The shunto negotiations involve only the largest companies who employ but a sliver of the overall labor force. The key question always was whether small and medium enterprises (SMEs) would also hike wages. According to a survey by the Japan Chamber of Commerce and Industry (JCCI), just a third (34%) of SMEs have raised base pay since April 1^st, while others raised seniority pay or applied some special one-time-only allowance. As noted earlier, the base pay is what counts for an overall rise in labor income.

            There is one possibly encouraging sign for wages. Only a third of SMEs who increased pay did so because of improved performance. The other two-thirds did so because labor shortages or the shift of their employees to better-paying firms forced their hands. The increase in labor mobility is an important factor in strengthening workers’ bargaining power.

The BS-TBS Hodo 1930 (News Report at 7:30 PM) interviewed me on May 23, BS-TBS is part of the Tokyo Broadcasting System.

It was about my blog post on Japanese automakers losing sales due to their resistance to Electric Vehicles (EVs). As I reported, Japan is about to be surpassed by China as the world’s largest exporter. The focus was on my view that Japan today is acting like the Detroit Big Three did in the 1970-80s. II made the point that, “The more successful you are along a certain business model, the harder it is for you to recognize that times have changed.” It is not a problem just of Japanese companies, but of most successful companies.

            The segment on EVs begins around minute 15:55, Comments by me begin around 29:10 and go on a few times over the next 10 minutes, and then experts discuss my view and other matters related to Japan and EVs for the rest of the program. The latter part began with a discussion of this poster:

It reads:

When fuel-efficient Japanese cars showed up, the Big Three thought it was a temporary danger. 

Companies that are too successful may not notice changes

Maybe Japanese carmakers will suffer the same fate as the Big Three.

The person who interviewed me provided this gist of the conversation:

The anchor, Koji Matsubara, a former TBS New York Bureau Chief, said my analysis reminded him of the famous book, The Innovator's Dilemma by Clayton Christensen. That book describes how very successful innovators can taken by surprise by a new innovation that they dismiss.

Economic analyst Keiichi Kaya, who, among other things, consults with government agencies, said Japan does seem to be caught in this Innovator's Dilemma. It’s also similar in some ways to the shift from sailboats to steamboats: Sailboats had good workmanship and well-refined technologies while steamboat makers could only produce small ships at first. But, once the shift to steam happened, the sailboat makers were too late to realize the need to change and all but disappeared. You can see a similar pattern across many industries, including autos. The move from internal combustion to EV and hardware to software emphasis is a huge paradigm shift and is already well underway.

Toshiyuki Shiga, a former Nissan Chief Operating Officer (2005-2013) added: There tends to be an emphasis on Japan falling behind in EV development, but there is an even bigger problem in how the fundamental manufacturing and usage of cars is shifting, such as using software updates to improve functionality even after purchase. Japan's industrial structure itself is not adapting to these changes quickly enough. It's not as simple as internal combustion engines being replaced with EV motors or gas tanks being replaced with batteries. The latest EV automobiles worldwide are Software-Defined Vehicles (SDVs), which allow continuous updates to the car's functionality and performance through software. Japan's automakers need to employ more software engineers and alter the pyramid-structured manufacturing process to create hardware that can better incorporate software updates.

Auto analyst Takaki Nakanishi, the CEO of the Nakanishi Research Institute, added: It’s not necessarily a problem that Japanese automakers are exploring many options. However, treating this search as an end goal in itself rather than merely part of the process in the quest for the best carbon-neutral option is a mistake. [He was referring to the strategy of Toyota to pursue EVs, Hybrids, Plug-In Hybrids, and Hydrogen Fuel cell cars all at the same time on the grounds that different markets want different kinds of autos.] Furthermore, this process has many steps, and the first step is succeeding in the EV market. Carbon-neutral fuel and perhaps hydrogen may be options in the long run, but those will take time and major infrastructure development. Even if Japan wants to keep pursuing its multi-faceted approach, it must first compete successfully in the EV market. Seeming to skip out on the EV market and putting too much emphasis on hydrogen was a mistake. Even two to three years of this approach has created a huge gap in competitiveness for Japanese automakers. Pursuing other options on top of EV is fine, but EV has to be prioritized first.

Source: https://www.e-stat.go.jp/en/stat-search/file-download?statInfId=000032103932&fileKind=1

 [This is what I believe Bank of Japan Governor Kazuo Ueda thinks about critics who say he will be compelled to raise interest rates in the near future. Some is based on public information, some on my conversations with people in the know, and some is surmise on my part based on how BOJ statements relate to certain economic trends. Anything in quote marks is genuine. As with my January post on reading the mind of Haruhiko Kuroda. my purpose is to show why Ueda thinks current policy is both correct and sustainable.]

            I don’t understand why many major players in the financial markets are still telling their clients and the press that I will raise interest rates during the coming months, even though I’ve repeatedly declared that I will not. Here’s a typical example from a former top BOJ economist named Seisaku Kameda, who told Reuters soon after I became Governor, “Wages are rising and domestic demand is firm...The BOJ may see scope to tweak YCC as early as June.” YCC (yield curve control) refers to our policy of setting rates, not just for overnight instruments like other central banks, but for notes and bonds of all maturities. Without YCC, long-term interest rates would rise. I’m not going to do that any time soon, certainly not just a few weeks from now.

A Reuters poll taken April 12-19 showed over half of economists predicted an end to YCC control by year-end. So, I’ve had to repeat my message and make it even more firm. In my May 19 press conference, I again pointed out that today’s high inflation in Japan is a result of temporary factors. So, it would hurt the economy to raise interest rates as if high inflation were going to last. “The cost of prematurely shifting policy, and nipping the bud towards achieving 2% inflation, is extremely large. It's appropriate to take time to judge when to tweak ultra-easy policy toward a future exit...It will take time to shift public perceptions that prices and wages won't rise much.” Until those perceptions shift, and wages actually rise, we won’t enjoy 2% inflation on a sustained basis.

            In our April 28 “Outlook” report, the BOJ Board projected that our measure of core inflation—all items minus fresh food and energy—would have risen 2.2% in fiscal 2022 (which ended March 31^st, 2023), then will accelerate to 2.5-to-2.7% in fiscal 2023, and finally fall back to 1.5-1.8% in fiscal 2024.

            Yes, we could be wrong. Prices could keep rising faster than we expect. But policymakers always have to figure out how to balance risks. What is the harm if we tighten rates too late vs. the harm if we tighten rates too early? As I said, “The cost of waiting to ensure inflation is sustainably at 2% is smaller than shifting policy prematurely.” That’s because it’s easier to curb inflation than to overcome deflation.

Can the Market Force My Hand?

Critics believe that events beyond my control in terms of inflation and market turmoil will force my hand. They felt the same thing regarding my predecessor last fall. They were wrong then and they’re wrong now.

            In fact, I’m under less pressure than Kuroda. During his tenure, the bank set the maximum rate on 10-year government bonds (JGBs) at 0.25%. Because the majority of market traders felt sure he would have to raise rates, they sold JGBs, which caused rates to rise. The BOJ had to spend a lot of money buying JGBs to fight this pressure. Finally, like releasing a pressure valve, Kuroda lifted the 10-year rate ceiling to 0.5%. Lots of market players believed that, having forced Kuroda to do that once, they could force him to do it again to, say, 0.75%. That never happened. His tactic worked. Since then, the 10-year rate has fluctuated around 0.4%. This tells me that the majority of traders realize that the BOJ has the power to sustain its policy; they fear losing money if they bet against us.

Consequently, the tide of opinion is changing. For example, Shigeto Nagai, head of Japan economics at Oxford Economics, recently told clients, “Ueda’s game plan appears to have a longer time frame than we had thought We believe it is more likely that the status quo will continue in the coming quarters.”

Japan’s Inflation is Temporary “Cost-Push” Unlike US and Europe

Here’s what the critics don’t get. Central bankers distinguish between two kinds of inflation: cost-push vs. demand-pull, and, unlike the US and Europe, Japan is mainly suffering from the former. By contrast, demand-pull happened in the US because the government gave consumers and companies so much cash to fight a possible recession arising from Covid.

            Japan’s cost-push began when energy and food prices skyrocketed due to Russia’s invasion of Ukraine, and the weakening yen amplified that price shock. When the yen gets weaker, Japanese have to pay more for imports, e.g., having to pay ¥140 for products that sell for $1 in the international market instead of ¥1.25.

            As a result, inflation in Japan will recede when international prices come back to earth. The BOJ’s critics believe that price hikes are spreading throughout the economy, and creating expectations of continued price hikes. So, they say, what started as cost-push inflation is now feeding on itself.

            But there’s little evidence for that view, at least not so far. Virtually all of the inflation in the last couple of years has arisen from the import-heavy food and energy sector. Inflation in the whole rest of the economy is barely above the 2% level. Moreover, inflation in food and energy has come down a great deal (see chart at the top). Of course, a year from now, things may look very different. But in which direction: higher inflation or lower? No one knows for sure, although the odds are that inflation will peak sometime in this fiscal year. So, the least dangerous course is to wait and see, and carefully follow the data. If the evidence changes, the BOJ can shift, and little will have been lost.

           We also have to watch movements in the yen very carefully because it greatly impacts the price that companies and households pay for import-heavy items. Only a couple of months ago, many traders saw the yen strengthening to ¥125/$. But, due to a rise in long-term US interest rates, the yen has weakened again to ¥138 (see chart). The recent rise in US rates may be the result of anxiety over whether the US will raise the debt ceiling. But, if the yen remains this weak, that will place upward pressure on prices in Japan and, depending on how much the yen weakens, and for how long, delay the downshifting of inflation.

The New BOJ View: 3% Nominal Wage Hikes Are Indispensable

Back in 2012, when Kuroda became Governor, he believed that he could create 2% sustained inflation in just two years just by unleashing a “big bazooka” of monetary ease. Monetary stimulus needed no help from fiscal policy or changes in the real economy like wage hikes and such.

            That turned out to be wrong and Kuroda adapted. He realized that, while monetary ease was necessary, it was not sufficient. While Kuroda never explicitly acknowledged this shift, his speeches focused more and more on the need for wage hikes. He argued that such hikes were indispensable to create a virtuous cycle of wages, demand growth, and prices.

            It will take steady 3% annual growth in nominal wages to produce our goal of 2% consumer price inflation. Here’s the arithmetic. Productivity growth (output per worker) is around 1%. So, if nominal wages go up 3%, then the labor cost to companies to produce a good or service is 2%, i.e., 3% wage hikes minus 1% productivity growth. Companies will pass this 2% hike in their costs onto customers. Workers, in turn, will enjoy a well-deserved 1% growth in “real” wages, i.e., nominal wage hikes of 3% minus inflation of 2%.

            One of the main reasons that deflation and then weak price hikes have been so prolonged is that workers have suffered negligible or negative real wages for years. In the past five years, nominal wage hikes came close to 3% only once: in Oct-Dec. 2022. Meanwhile, real wages have fallen for years. In January-March of this year, real wages fell a huge 3.4% from last year (see chart below). One consequence was that household spending in March was down 1.9% from a year earlier. How can consumers spend more, and thereby put upward pressure on prices, if their real income is falling?

Source: https://www.mhlw.go.jp/english/database/db-l/monthly-labour.html

            For years, forecasters have predicted that Japan’s labor shortage would create substantial wage hikes due to the laws of supply and demand. That, however, has not happened. Consequently, no one really knows whether or not wages will rise a great deal for the overall labor force just because big companies reached deals for an average of 3.7% wage for unionized workers. The workers involved in the annual “shunto” wage negotiations comprise only a small sliver of all employees. Maybe wages will rise broadly. However, “there is extremely high uncertainty over the sustainability of wage hikes, consumption, and overseas economies.” Let’s wait for data on wages for the workforce as a whole to come in over the next few months.

GDP Recovery Slow

The slow pace of economic recovery is another factor raising doubts about Japan’s future inflation rate. In January-March, GDP was still 1% below the level reached five years earlier in 2018 and only 4% above the average ten years earlier in 2013 (see chart). The economy is still operating below its capacity. A slack economy usually portends less upward pressure on consumer inflation.

Source: https://www.esri.cao.go.jp/jp/sna/data/data_list/sokuhou/files/2023/qe231/tables/gaku-jk2311.csv

Source: Cabinet Office at https://www.gender.go.jp/english_contents/about_danjo/whitepaper/pdf/5th_bpg.pdf

It was a thrilling moment. The Japanese Prime Minister vowed to raise to 30% the number of female managers at private companies—and to do so in 13 years. That PM was Junichiro Koizumi, and the promise was made in 2003. Ten years later, Shinzo Abe repeated the 30% promise with the same 2020 deadline. Two years later, he admitted the goal would not be reached and halved the target to 15%. That, too, was not reached. Now, another ten years have passed, and yet another Prime Minister, this time Fumio Kishida, has vowed that 30% of corporate executives will be women. Once again, seven years is the promised timeline.

            Kishida, like Abe and others before him, has a habit of announcing lofty goals without creating any effective measures to turn the goal into reality. He says he is appointing a committee to come up with measures, but he did the same regarding other big issues, from creating startups, to raising the birth rate, to fixing the maldistribution of income, and reviving nuclear power plants.

Moreover, Kishida’s goal is less lofty than that of Koizumi and Abe. Kishida referred only to executives, not all managers. Moreover, he only talked about this goal being reached by top companies in the prime section of the stock exchange, where only a sliver of Japan’s workers are employed.

So far, empty promises are working for Kishida, if not for Japan. His poll ratings have bounced back to levels good enough to keep him in power: 52% in the latest Nikkei poll. Moreover, his Liberal Democratic Party (LDP) has done well in a series of recent local elections.

Glacial Progress

It’s not as if there has been no progress on women’s equality in companies. But the pace has been glacial pace. Thirty years ago, women held less than 5% of kakaricho (sub-section chief) posts. That’s the first rung on the ladder, and one attained by almost all men. By 2019, the female share was up to 19% (the government has not announced more recent data). During the same period, the female share of kachos (section chief) has risen from 2% to 11.4%. Among buchos (department heads), it has risen to 6.9% (see chart at the top).

            Those women who do get managerial roles acquire them much later in life. Within five years of joining the management track at a sizeable firm, 14% of men have been promoted to the post of kacho, but just 1% of the women. By the 20th year (age 42 for a college grad), a third of the men have attained the level of kacho or higher, but just 8% of the women. That limits the opportunity for future promotion all the way up How can women become 30% of executives if so few have even reached the bucho post?

Moreover, many firms seeking to show good numbers give women a managerial title but not the authority and the experience that normally come with that. In her 2016 book, Too Few Women at the Top, Kumiko Nemoto cites a thirty-eight-year-old male deputy general manager in a bank’s investment banking section, who reported that he does not see many female managers in the workplace who possess real organizational power. “Many of them have been given the job title but no subordinates to manage.”

Source: https://www.jil.go.jp/english/JLR/documents/2016/JLR51_yamaguchi.pdf

Japan Ranks 131st

If the government wants to have more women managers, get equal wages, etc., the first step is just to enforce the law, which outlaws gender discrimination on wages and promotion. And equal promotion is just one part of the problem.

            Women are paid less even when other factors, like occupation and education, are equal. Men and women with university degrees start at around the same pay at age 20-24. By the time the male reaches 50-54, his pay has almost tripled, but a woman’s pay has just doubled. According to the World Economic Forum, among 153 countries in 2020, Japan ranked 67th for wage equality, 110th for the number of professional and technical workers, and 131st for leadership roles in government and managerial roles in companies.

            Having lower salaries means women accumulate less money to pour into a firm, so a female-founded firm is likely to be smaller and hence less successful. So, there are far fewer female entrepreneurs. Beyond that, banks are even more reluctant to lend to women. Only 12% of female-owned startups got bank loans vs. 26% for men.

Mr. Kishida: Just Enforce the Law

All this discrimination is at odds with Japan’s Labor Standards Act, whose words seem quite clear: “An employer shall not engage in discriminatory treatment of a woman as compared with a man with respect to wages by reason of the worker being a woman.” In addition, the 1986 Equal Employment Opportunity Law (EEOL) forbids discriminating against women on matters of promotion, or even using criteria that appear to be gender-neutral but result in discrimination. These laws are routinely ignored and there is no government agency mandated to enforce them. The victim must spend her time and money to seek redress in court. Worse yet, class-action lawsuits are not available in labor cases.

            A lawyer who always represents companies in such suits told me that his clients routinely get around the “equal pay for equal work” principle by tweaking the job description, to argue it is not equal work. The courts almost always back the employer in such cases. Even when, in response to complaints, a government agency finds that a firm has violated the law, it is just given an administrative order to rectify its practice but is not penalized.

            By the way, the same anti-discrimination laws apply to non-regular workers, and there is no enforcement in that case either.

            Partly in reaction to the anti-discrimination clauses of the EEOL, firms created two separate tracks: ippan shoku (clerical or general track) dominated by women and nicknamed “the mommy track” and the sogo shook (managerial track) dominated by men. As late as 1992, 40% of firms felt no shame in justifying the track system by saying that they put women into jobs “for which the female and sensitivity can best be used.” At age 45, a person on the management track will earn nearly 2.5 times as much as his counterpart on the general track. As of 2011, about half of firms with at least 1,000 employees still acknowledged using this two-track system.

            The solution is to mandate that the Labor Ministry investigate and penalize violations of the law. Japan does have labor inspectors who examine the practices of individual companies. But mostly, they focus on violations like excessive overtime or lack of payment for overtime. They regard matters of equal pay as a contract dispute and not within their purview.

            If Kishida wants to be serious, he would mandate that these inspectors investigate discrimination on pay and promotion, and he would ensure that the Labor Ministry penalize violations via stiff fines and publicity. Despite talk of “womenomics,” Abe declined to take this obvious step. Alas, Kishida’s track record on matching goals with measures does not give reason for much hope that he will do any better.

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Note: Passenger cars only, no light trucks like SUVs or pick-ups; much of the decline in overall exports in 2020-22 reflects the shortage of computer chips triggered by Covid

Source: https://www.bloomberg.com/news/articles/2023-01-26/how-china-is-quietly-dominating-the-global-car-market

Three recent bits of news made me wonder whether Toyota and its fellow Japanese automakers are risking a repeat of the decline of the Detroit Three, all because of their resistance to electric vehicles (EVs).

            The first item was the news that 40% of Americans who bought Teslas had switched from Japanese brands, primarily the Toyota group and Honda (see chart below). Even though so many Teslas are priced like luxury cars, the biggest losers include models aimed at the middle-class market. The top five Model Y conquests are the Lexus RX, Honda CR-V, Toyota RAV4, Honda Odyssey, and Honda Accord. Meanwhile, the top five Model 3 conquests are the Honda Civic, Honda Accord, Toyota Camry, Toyota RAV4, and Honda CR-V. Imagine the difference if Toyota and Honda had been offering EVs. Once brand loyalty is lost, regaining it is not so easy.

Note: Brands from which Tesla buyers switched; Toyota group includes Toyota, Lexus, and Subaru

Source: S&P Mobility at https://www.spglobal.com/mobility/en/research-analysis/new-ev-entries-nibbling-away-at-tesla-ev-share.html

            Secondly, at a time when 25% of new car sales in China consist of EVs and plug-in hybrids, Japanese brands are losing sales in that country due to their lack of EV offerings. China’s sluggish economy meant that total auto sales fell in the first three months of this year, but Japanese brands tumbled the most, a serious 32% year-on-year sales decline. This compares to just 9% for American and European brands, and 7% for Korean makes. Losing share in the world’s biggest market with the fastest growth does not bode well.

            The final item, the most shocking of all, is that, in 2022, China surpassed Germany to become the world’s second-largest auto exporter, and it is on track to surpass Japan in the next few years. (The chart at the top includes only passenger cars where China did not quite surpass Germany; counting cars plus light trucks, China exported 3.1 million autos compared to 2.6 for Germany and  4.36 for Japan).

            This, too, is largely because of EVs, which accounted for half of all Chinese auto exports in the last few months of 2022. True, many of these auto exports are made by foreign brands like Tesla and GM’s joint venture with state-owned SAIC producing vehicles on Chinese soil, mostly in joint ventures with Chinese companies. Increasingly, however, the EV exports come from Chinese companies like BYD that have no joint ventures with foreign companies and which export EVs to richer countries at prices aimed at the middle class (around $30,000 or so). As a result, China’s exports no longer focus simply on developing countries. In the first half of 2022, Western Europe accounted for around 34% of China’s total passenger car exports. Fitch Solutions predicts that China’s share of the European EV market will rise from 5% in 2022 to 15% as early as 2025. So, Japanese brands are losing sales to their Chinese counterparts in global markets as well as in China.

Repeating Detroit’s Sad History

The irony is that Chinese brands seem to be doing to Japanese automakers exactly what the latter did to the Detroit Three. Moreover, it is doing it for the same reason: a shift in technology and market conditions that dominant oligopolists dismiss and fail to adapt to. In the case of autos, the trigger for Detroit’s decline was skyrocketing oil prices and thus growth in demand for smaller cars. Today, it’s EVs.

            Until the two oil price shocks of 1973-74 and 1979-80, the Detroit Three’s oligopoly seemed unassailable. Throughout the 1960s-early 1970s, its market share in America held up at a stunning 85%. When oil prices suddenly rose, Japanese brands seized the opportunity to offer smaller, reliable fuel-efficient cars while Detroit refused to do so. In fact, Detroit never learned how to produce small cars profitably. These days, they make most of their money on SUVs and pick-up trucks. Today, Detroit’s US market share is down to just 40%.

            Toyota is now the world’s biggest automaker, a status that General Motors had enjoyed for 77 consecutive years. And just as success blinded GM to a change in the times, so it has done the same to Japanese brands. Just-retired Toyota chieftain Akio Toyoda dismissed EVs as over-hyped and repeated the myth that a shift to EVs would actually increase carbon emissions because of the increased need for electricity, which is largely produced by fossil fuels.

            Toyoda’s successor, Sato Koji, told the press at his first meeting with them, “We will thoroughly implement electrification, which we can do immediately.” But we’ve heard similar comments over the past year or two and many auto analysts remain skeptical on grounds of both intentions and capabilities. Bloomberg New Energy Finance forecasts that, come 2030, EVs will comprise a minuscule 2.5% of the total number of passenger vehicles on the road in Japan, compared to 13% in the US and 23% in Germany.

            The Japanese automakers seemed to have assumed that they could pursue their emphasis on hybrids and that, if and when the time came to focus on EVs, they could play catch-up. But it is not clear that catchup will be easy, not just because of brand loyalty issues, but also due to internal corporate culture. It is common among highly successful companies for managers and engineers to become too attached to the business model and technology that brought them success in the first place. They often look down on seemingly less sophisticated technologies that end up overthrowing their dominance. The famous book, The Innovators Dilemma, details this pattern in industry after industry. The Economist, in a piece headlined “How Japan is losing the global electric-vehicle race,” reported that, “Engineers at Japanese firms that fine-tuned complex hybrids were also unimpressed by EVs, which are simpler mechanically.”

            Japan’s government and automakers have become stubbornly obsessed with the romance of cars powered by hydrogen fuel cells rather than batteries, part of a notion they hype as the building of a hydrogen society. In fact, the government throws more subsidy money down the sinkhole of fuel cell cars than it devotes to EVs. The country has been working on fuel cell cars for years and years, and results have consistently fallen far short of puffed-up forecasts. Prior to the 2021 Tokyo Olympics, Tokyo claimed that the games would be powered by electricity produced by fuel cells using green hydrogen and that participants would be transported by cars running on hydrogen fuel cells. In a comment typical of the bombast, former Tokyo Governor Masuzoe Yoichi boasted, “The 1964 Tokyo Olympics left the Shinkansen high-speed train system as a legacy. The upcoming Olympics will leave a hydrogen society as its legacy.” In reality, instead of the whole Olympic Village, only one building was fueled by hydrogen. And only a few buses on short routes were powered by fuel cells. The Mirai, Toyota’s fuel cell car, has sold only 22,000 cars worldwide since its introduction almost a decade ago.

Autos Just Part Of A Common Pattern

Far from being unique, the reversal of fortune bringing down seemingly invincible giants has been seen in industry after industry. Typically, when an industry is new, a host of companies enter the field. Between 1895 and the 1930s, more than 1,300 car companies were born and died in the US alone, some running cars on steam, some burning wood or gasoline, and, ironically, still others using batteries. Once a dominant technology emerged, the field narrowed to the Big Three and a few niche players. In industries where rapid technological shifts are frequent, like electronics, the rise and fall of companies is equally frequent. In fields, like autos, where the fundamental technology remains stable for a long time, a few companies can dominate for decades.

            However, when there is a big, abrupt shift in technology and market conditions that undermine the existing business model, the dominant players are likely to stay with the old technology and business model for too long because they underestimate the shift in front of their eyes, That gives room for new challengers to rise. Back in the 1960s-70s, such shifts enabled Japanese companies to displace US giants in several important fields. In TVs, the Japanese moved to solid-state technology ahead of their US counterparts. In steel, as US companies stuck with the older open-hearth technology, Japanese companies moved to the more efficient basic oxygen furnace. In computer memory chips (DRAMs), Japanese companies produced more densely-packed chips, the 16K and 64k generations, at a lower cost ahead of the US leaders. Rather than perceiving the reality of their strategic blindness, Americans seized on various practices by Japan to claim the main, or even sole, explanation was alleged cheating by Japan, a charge leading to decades of trade friction.

            Today, Japanese oligopolists wear the same sort of perceptual blinders. Japanese steel companies lag in using electric arc furnaces, causing them to emit more greenhouse gases than their international competitors. They create a stunning 14% of Japan’s total carbon emissions.

            Japanese firms suffer an additional problem hobbling their ability to adapt to change Due to almost exclusive promotion from within the company, executives find it hard to abandon a product or technology championed by the seniors who sponsored them. That would feel like a betrayal. It’s one of the reasons companies like SONY lost billions of dollars over many years by sticking with TVs for far too long. Can new CEO Koji stray very far from the strategy trumpeted by Toyoda?

            It is not foreordained that Toyota, Honda, et. al. will fall victim to this common pattern. But time is not on their side.

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Source: Cabinet Office at https://www.esri.cao.go.jp/en/sna/data/sokuhou/files/2022/qe224/gdemenuea.html

Japan’s GDP disappointed in the fourth quarter of 2022, growing at a meager 0.6% annual rate. Economists had predicted a 2% rebound following the 1% annualized drop in the previous quarter. As a result, GDP is still below the level it first reached five years ago in 2017. That was before Japan was hit by the double whammy of a hike in the consumption tax in October 2019 and then Covid (see chart above).

            This puts into question the IMF’s forecast that, in 2023, Japan will show the highest GDP growth among the big Group of Seven countries.

            There’s one caveat here. This is a preliminary report, issued before the government has gotten full information on business investment in October-December. When a final report is issued in a few weeks, the number could be revised upward or downward.

Very Slow Growth In Past 15 Years

Regardless of the quarterly ups and downs, what remains clear is that Japan has shown incredibly meager growth in the 15 years since 2007 as seen in the chart below. The lost decades have not ended—at least not yet.

Note: The big GDP decline in 2008-09 was due to the global financial catastrophe

            Real GDP is up only 4% from 2007, an annual growth rate of only 0.2%. Private domestic demand—personal consumption, business investment, and housing construction—is back down to the level first reached in 2007. By contrast, government spending is up 20% and has provided almost all of the GDP growth. It is the weakness of private demand that has compelled Prime Minister after Prime Minister, including the current one, to lift spending.

            The outright zero growth in private demand is due to a 25% decline in housing construction. That’s not a surprising development in a country where the population is both shrinking and aging. This may surprise those gazing at all the construction cranes building splendid apartments in metropolitan Tokyo, but it’s not surprising to those who see the countryside littered with about 4 million abandoned homes.

            However, housing is not the whole story. If the main components of private demand—personal consumption and corporate investment—were healthy, total private demand would be a lot bigger today. However, growth in these two categories has been anemic. Personal consumption is up only 1% compared to 2007, while business investment is up only 2% (see chart below).

            Why is personal consumption so stagnant? Mainly because personal income is stagnant. Total real compensation for all employees combined showed a temporary burst in the Abe era as more women and elderly entered part-time and temporary work, but it has now fallen back. It’s now just 3% above its level 15 years ago (see chart below). At the same time, interest income from banks and insurance annuities is down due to the Bank of Japan’s near-zero interest rate policy. To top it off, government social security per senior is down 20% from 1996 and governments have repeatedly raised the consumption tax. How can policymakers expect households to spend more if they leave them with less to spend?

As for the stagnancy of corporate investment, why would companies invest in expansion, or even modernization of equipment, if consumer demand is so stagnant? Growth in exports can only offset this drag on investment to some degree.

It Ain’t Just Population Decline

Perhaps, some might wonder, the numbers look so bad because Japan’s population is declining. Let’s take a look. The population peaked in 2010 at 128.1 million. By 2022, it had fallen by 3%. So, demographics makes some difference, but not all that much. GDP is up 3.7% compared to 2007. Per capita GDP is up 6.8%. So, GDP increased at a dismal rate of 0.2% per year and per capita GDP at a slightly less dismal rate of 0.4% per year (see chart below).

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Source: https://www.mhlw.go.jp/english/database/db-l/r04/2211pe/2211pe.html

(Let’s imagine we can read the mind of Bank of Japan (BOJ) Governor Haruhiko Kuroda. I am not saying I agree with him. I’m just saying he has his reasons; he is not simply stubborn. BTW, Kuroda’s term ends on March 31, and the choice of his successor, most likely in February, will be the next big signal of future BOJ policy.)

——————————————-

I fought the market and the market lost—and lost big. All those speculators who believed I had no choice but to raise interest rates on Wednesday (Jan. 18) sold to the BOJ a record ¥16.2 trillion ($125 billion) worth of Japan Government Bonds (JGB)—an amount equal to 3% of GDP. They believed that I could not resist market pressure. After all, by January 17 when the BOJ Policy Board began its two-day meeting, the market had already raised interest rates above my 0.5% line on the sand for 10-year JGBs.

            But I refused to cave. And guess what happened? Yields have fallen. In fact, the rates on 7-, 8-, 9-, and 10-year JGBs are now all at or below my target (see chart below). As a result, the price of existing JGBs is higher than it was when they sold them to the BOJ. [When interest rates go up, the value of existing JGBs goes down and vice versa.]

Source: https://www.mof.go.jp/english/policy/jgbs/reference/interest_rate/index.htm

            So, those who sold JGBs “short” lost boatloads of money. This loss will make them more hesitant to bet against the BOJ next time. [Selling short means borrowing JGBs, selling them, and then buying them afterward in anticipation that their price would have fallen by then. But if their value goes up, they have to pay more than what they sold them for, and they lose money.]

            Yes, I know that there are lots of economists and speculators who think it’s just a matter of time before the markets push rates up again and the BOJ is forced to yield. [Former BOJ official Nobuyasu Atago told Reuters that, “The BOJ can't keep on manipulating markets like this. At some point, it needs to let market forces drive yields.” Takatoshi Ito, occasionally mentioned as a dark horse candidate to succeed Kuroda, stated, “Mr. Kuroda argues that the BOJ hasn't started moving toward the exit [from its current policy]. But the BOJ has already put its shoes and coat on.”]

They think it will happen sometime after the new BOJ Governor replaces me because they believe the current policy is unsustainable. But they’re wrong. This policy is sustainable and time is on the side of the current policy.

Market Is Misreading Japan’s Inflation Trends

For one thing, these speculators are looking at headline numbers for Japanese inflation and see that, in December, Japanese-style “core” prices—i.e., all items except for fresh food—were 4% higher than last December. That’s the highest year-on-year rate of inflation in 40 years (see chart below).

Source: https://www.e-stat.go.jp/en/stat-search/file-download?statInfId=000032103932&fileKind=1

            In fact, both Nikkei and Kyodo mistakenly reported that the BOJ was considering raising its inflation forecast for 2023-24 to something above our 2% target. In reality, we kept our forecast the same, at 1.6% inflation for fiscal 2023 [which begins April 1st], and raised the 2024 forecast by just a smidgen to 1.8%.

            People who say this need to look more closely under the hood of the latest inflation numbers. They not taking into account the volatility of prices for food and energy, which we must import. Prices for both categories are now going down globally, as we had expected. On top of that, with the yen now stronger than in November, we don’t need to pay as much in yen terms for our imports of food and energy as we did a couple of months ago. That puts more downward pressure on inflation.

            Secondly, while the headline numbers look like a big leap compared to a year ago, that’s partly a statistical illusion. It’s due to a recovery of prices from their fall during Covid. If we look at the price level for US-style core inflation (all items except food and energy), core prices are lower today than they were pre-Covid. Moreover, core prices in December were no higher than they were in October (see grey line in the chart below). Consequently, as we go further into 2023, year-on-year comparisons will shrink.

Higher Inflation Needs Bigger Wage Hikes

When I first launched my monetary “bazooka” back in 2013, I truly believed this would cause a big shift in “inflation expectations” among companies and workers. If companies and households truly believed that inflation was heading to 2%, then workers would insist on higher wages, companies would willingly give it to them, and households would spend more today before prices went up later on. That increased demand would help push prices up. It would be a grand virtuous cycle, a self-fulfilling prophecy. All this could be done in just two years.

            Unfortunately, while I’ve conquered deflation, I’ve not yet reached the 2% target on a sustained basis.

            We’ve had a lot of in-house discussions about this. Most of us now believe that, without nominal and real wage hikes, monetary policy alone will not be enough to reach 2%. Unfortunately, nominal wage hikes have been dismal over the past dozen years. Companies are earning big profits but not spending them on wage hikes. And we’re still discussing why. Nominal cash earnings per month (including overtime and bonuses) in 2022 were just 2% over their level way back in 2010. (see chart at the top of this post.)

            That’s why my speeches repeatedly say we need sustained inflation with wage hikes. To reach 2% inflation, nominal wages need to go up by 3% per year. Here’s why: if productivity (GDP per workhour) goes up 1% per year, then, to afford a 3% wage hike, companies need to raise prices 2% per year.

            The big union federation, Rengo, is asking for a 3% hike in base pay this year and I hope they succeed. But there’s certainly no guarantee and the BOJ should not raise interest rates until we see the needed wage hikes. Polls of companies are not as encouraging as I had hoped. Companies divide pay hikes into “base pay,” which raises the wages of the entire workforce, and “seniority pay,” the average increase in wages per worker as workers age. The latter raises the wages of individual workers as the years pass but does not raise the overall wage bill. That’s because lower-paid new workers replace the higher-paid older workers as the latter retire.

            According to a Reuters poll of big companies, just 24% of them intend to raise base pay, but it’s not clear by how much. 29% will increase seniority wages, but not base pay. And 38% are still undecided. Some corporate giants like Uniqlo and Rakuten are planning huge wage hikes, as much as 40% says Uniqlo. But they are the exception. Equally important, big companies employ only a fraction of the workforce. The small and medium companies that employ 70% of all employees are not likely to provide significant hikes, if any at all, according to most economists.

            Besides, with companies fearing that the US will enter some sort of recession, many will be hesitant to raise base wages. They’re more likely to give one-off bonuses.

Look At American Inflation and Interest Rates

People who think the BOJ is wrong about Japan’s inflation need to take a closer look at the US, where the inflation picture is rapidly improving. As the Wall Street Journal pointed out, “While December 2022 prices were up 6.5% from a year earlier...annual growth has eased to levels that existed before the pandemic. Inflation observed during the past six months would extend to prices rising 1.9% over the course of a year, close to the average annual rate of 1.7% between 2010 and 2020.”

            Consequently, American interest rates are trending downward, and so the gap between American and Japanese rates has shrunk. That’s why the ¥/$ these days is around ¥129 instead of ¥150 like it was back in November. That reduces pressure on the BOJ to raise rates just to bolster the yen.

The Next Governor

I cannot guarantee what policy will be pursued by my successor; nor can I bind him to continue my policy. But I feel no need to change BOJ policy to “pave the way” for him with higher rates, as some observers have suggested.

Source: MOF at https://www.mof.go.jp/english/policy/jgbs/reference/interest_rate/index.htm

The market is upping the pressure on Bank of Japan (BOJ) Governor Haruhiko Kuroda to raise interest rates. The BOJ, in response, has spent 5% of GDP in so-far-unsuccessful efforts to keep interest rates down through massive purchases of Japan Government Bonds (JGBs). Despite this, rates are already above the maximum level the BOJ had said it would allow. 

Consequently, there is a growing view that, sooner or later, the BOJ will have to yield. Some investors say the BOJ will make another “tweak” in raising rates as early as this coming Wednesday when the BOJ Policy Board finishes a two-day meeting. Others say it will take until March. Others think nothing will happen until after a new Governor replaces Kuroda in April. Still others believe the BOJ will move back to controlling only overnight rates and let the market determine longer-term rates. And, finally, there are those who think the BOJ can win, though not as many as a couple of months ago.

Even if the BOJ does decide on another “tweak,” some traders suggest it may do so in a surprise move, as it did on December 20.

BOJ Spent 5% of GDP In Losing Effort To Hold Down Rates

On December 20, the BOJ made its first tactical retreat when it raised the maximum rate on 10-year JGBs from 0.25% to 0.5%. However, it had spent a lot of money in its futile effort to hold the line at 0.25% and has continued to spend money in its equally unsuccessful effort to hold the new line in the sand. During December, the BOJ spent ¥17 trillion, or 3% of GDP. On January 12 and 13, it spent another ¥10 trillion, or 2% of GDP, a daily record. As a result, the BOJ probably owns around 55% of all JGBs.

            This money is not working. The 10-year yield rose to 0.554% early Friday morning in Tokyo before settling back to 0.506%. And 8-year and 9-year bonds are fluctuating around an even higher level: 0.6% to 0.7% (see chart at the top).

            The reason it’s not working is that, for traders, the risk is one-sided. It’s almost certain that the BOJ is not going to lower rates unless Japan’s GDP suffers an unexpected slowdown. So, if they sell JGBs “short” to the BOJ and the BOJ is successful in keeping rates at today’s levels, they will have lost nothing. On the other hand, if interest rates do rise, that means that the price of existing JGBs falls. Hence, these traders will make big profits. Such one-sided risk creates a big incentive to make the bet. (“Selling short” means selling a security you do not yet own in anticipation that its price will fall, and then buying it later (“covering your short”) when the price is lower. If, as you expected, the price does fall, you can make huge profits.)

            The BOJ’s problem is not that it will run out of money. It can create all it wants. The problem is that its efforts are causing adverse side effects in the corporate bond market, something the BOJ does not want to see. Partly, this is due to the return of “the kink” in the “yield curve,” the line in the top chart showing the interest rate at various maturities. Normally, the longer the maturity, the higher the yield. But, these days, the rate on 8 and 9-year JGBs is higher than on 10-year bonds. That’s because most of the BOJ JGB-buying targets the 10-year bond. For technical reasons, a kink in the JGB yield curves causes serious distortions in the corporate bond market. A similar kink in December helped compel the BOJ to make its tactical retreat on December 20. A discussion of such side effects is on the agenda for this week’s BOJ Board meeting.

            In any case, the steepness of the yield curve has increased greatly since the beginning of the year and even more so since December 20th. This is a de facto tightening, contrary to the BOJ’s intention. That is likely to raise the interest rates that banks charge on loans. As of November, 37% of all loans charged less than 0.5% interest, and half of these loans charged less than 0.25% (see chart below). Rates are likely to rise somewhat, putting a burden on companies with scarce profits. How much lending rates rise will depend on supply/demand conditions in the loan market.

Source: Bank of Japan

The Role Of Inflation

The one thing that could help the BOJ’s efforts is a decline in Japan’s inflation similar to the decline the US is already enjoying. But so far that has not happened. On the contrary, Japan-style “core” inflation (all prices except fresh food) rose 4% year-on-year in Tokyo in December, the most in 40 years. A similar rise is expected when nationwide figures are released following the BOJ decision.

            The BOJ has consistently predicted that inflation would slow down this year as global prices for food and energy retreat. In its October Outlook report, the BOJ predicted that, after rising 2.9% in fiscal 2022, which ends in March, inflation would slow to 1.6% in fiscal 2023 and 2004. This is below the BOJ’s 2% target rate. A telling sign for future BOJ policy will be the prediction to be made in the Outlook report coming out of this week’s Board meeting.

What All This Means For The Yen

As we’ve repeatedly emphasized, the biggest short-term factor currently influencing the ¥/$ rate is the gap between 10-year government bond rates in the US and Japan. Not surprisingly, as the gap lessened—due to falling US rates and rising Japanese rates—the yen regained some of its losses (see chart below).

Source: US Fed, Wall Street Journal

            As the chart shows, the yen is now becoming stronger somewhat ahead of the change in the rate gap. The reason is that the yen moves, not only in response to the current rate gap, but also in anticipation of future rate gaps. That anticipation can be significant during times when a big change in rates is expected, in this case, a rise in Japanese rates.

This pleases the Kishida administration since 90% of Japan’s inflation comes from the rise in prices of import-intensive items like food and energy. A weaker yen means even higher prices and inflation is a factor in Kishida’s weak approval ratings.

            However, there is a limit to how much the yen can recover. Japan is fundamentally less competitive in international trade than it used to be. Its electronics companies, which used to run big trade surpluses, now run trade deficits. Its auto companies remain very competitive. However, the automakers now rely on overseas production, not exports, for 85% of their overseas sales.

            A nation that has become less competitive tends to suffer a weaker currency and that is the case for Japan. For any given gap between US and Japanese interest rates, the yen is about 20 points weaker these days than it was back in 2000-2013 (see chart below).

Source: Author calculation based on data from US Fed, Wall Street Journal

            I will be watching closely to see whether anything changes in this pattern. The black dots in the chart show the linkage between the rate gap and the yen’s value since December 20. At today’s situation, with a rate gap of around 3%, the black dots are a lot closer to the 2021-22 trend line than the 2001-13 trend line.

            The bottom line is that, even as the yen recovers from the nadir of ¥150/$, it will most likely remain a lot weaker than it has been during most of the past decade. That means Japanese households will continue to pay high prices for food and companies, as well as households, will continue paying high prices for energy. This is not a good sign for Japanese growth or well-being.

Source: http://www.mof.go.jp/english/jgbs/reference/interest_rate/index.htm

In the battle between the financial markets and the Bank of Japan (BOJ), who is winning? There is no question that market pressure forced the Bank of Japan on December 20 to do something it did not want to do: lift the maximum rate of 10-year Japan Government Bonds (JGBs) from 0.25% to 0.5%. But no one knows what this means for future moves in interest rates, the value of the yen, or financial market stability. For example, the yen leapt from ¥137 before the BOJ move to ¥131 the next day in New York. But much of this comes from traders betting that this rise in interest rates will be followed by further ones and they could be wrong. Financial markets often gyrate in response to a big surprise. So, it remains to be seen where the ¥/$ will stand in the coming weeks and months, as the market tries to size up the battle between bond traders and the BOJ.

            BOJ Governor Haruhiko Kuroda believes that he simply opened a “steam valve” to release the pressure and that the BOJ will be able to continue keeping interest rates at ultra-low rates. The move “was not a rate increase,” he told a news conference, but rather a technical measure aimed at “improving market functioning.” He moved because some distortions in the market for JGBs (to be explained below) were spilling over into the market for corporate bonds and some other financial markets. Raising the maximum rate on 10-year JGBs, insisted Kuroda, was not the first step in an exit from the BOJ’s decade-long strategy. “We have absolutely no intention of raising interest rates or tightening monetary policy.”

            BOJ officials have repeatedly stated that they want to see wages rise at least 3% per year on a sustained basis before they believe it is safe to lift interest rates. Some officials hope Rengo’s demand for a 5% wage hike in this year’s shunto negotiations means that the wage picture is changing. But, if, as economists now predict, the US and Europe will likely enter recession in 2023, it’s hard to see much wage generosity from Japanese companies.

            Many—but hardly all—traders believe Kuroda will be unable to persist in his stance. Having forced the BOJ’s hand once, market pressure can force it again, perhaps a few months down the road. The BOJ, in this view, has begun a de facto exit from Kuroda’s decade-long policy, even if the BOJ doesn’t realize it yet. Traders in this camp believe the next move could take place before Kuroda’s term ends in March or under the next Governor.

            This faction of traders points to two facts to justify their view. Firstly, although the BOJ only acted in regard to the 10-year JGB, rates rose all along the so-called “yield curve,” as seen in the chart at the top. That curve shows the rates on JGBs ranging from as little as one year all the way to 40 years. Rates are now far higher than they were at the start of the year when rates were negative on bonds with maturities as long as eight years.

            Secondly, the BOJ’s policy of “yield curve control” has caused a big distortion in both the government and corporate bond markets. Normally, as seen in the bottom line in the chart, the curve goes steadily higher as maturities of the bond get longer. However, since the BOJ only defended the 10-year JGB rate, the market in recent months was able to force the interest rate on eight and nine-year JGBs to a level higher than that on the 10-year bond. Traders point out that this distortion continues to exist even after the Dec. 20th move. Hence, if the distortion made the BOJ move once, they argue that it will inevitably force it to move again.

What Will Determine the Outcome?

While it’s impossible to tell which side is right, we can look at some factors that will shape the outcome.

            Firstly, if the BOJ is willing to spend enough money buying JGBs at all maturities, it can keep rates down. In fact, the BOJ just announced it will hike its purchases of JGBs from ¥7.3 trillion to 9 trillion yen per month, and will purchase as many 10-year JGBs as necessary to prevent the rate from going above 0.5%. However, that means that the BOJ, which already owns more than half of all JGBs, will own more and more. And that will increasingly cause problems for insurance companies and pension funds, which need to hold bonds as a source of income. JGBs now account for more than 35% of all assets of insurers and pension funds, down from 39% when Kuroda became Governor. Banks had also stocked up on JGBs as loan demand slowed and they grew to 18% of bank assets in 2012; now it’s down to 6%.

            Secondly, an abrupt and substantial rise in interest rates would have severe consequences. As rates go up, the value of existing bonds held by banks, pension funds, and insurers goes down, straining their balance sheets. Meanwhile, a quarter-century of near-zero interest rates has created a host of Japanese companies addicted to essentially free money. Today, 37% of all bank loans charge less than 0.5% interest, and, among these, half charge less than 0.25%. Given slack demand for loans, it is not clear how much bank lending rates would rise in tandem with JGB rates. However, if bank lending rates did rise even one or two percentage points, many companies with millions of employees would suddenly look a lot less solvent. Many of them would have to be bailed out by the government, which has issued credit guarantees and direct loans to about 40% of all SMEs. These add up to about 11% of GDP. However, the credit guarantees cover a maximum of 80% of the loan and so banks would suffer a surge in nonperforming loans.

            A third factor is the value of the yen. The steep fall of the yen over the past year and a half has been a big factor in the rise of Japanese inflation. In fact, 90% of the rise in prices during this period has come in the import-intensive food and energy sectors. That has been a big hit to consumer purchasing power. To the extent that the yen regains some of its lost value, that will reduce inflationary pressures and thus pressure on the BOJ to raise interest rates.

            Finally, there is the course of inflation. Kuroda believes, and correctly so, that most of Japan’s inflation is caused by the yen’s depreciation and the impact of supply chain blockages. Hence, he contends that Japan’s current inflation is temporary. In its October Outlook for Economic Activity and Prices, the BOJ predicted that, after rising 2.9% in fiscal 2022, inflation would decelerate to just 1.6% in 2023 and 2024. That’s lower than the BOJ goal of 2%. If the BOJ is right, then pressure on it to hike rates will ease. However, the BOJ does not have a good track record in its forecast. For example, just three months earlier, the BOJ’s July Outlook predicted inflation in fiscal 2022 would be 2.3% instead of the 2.9% it predicted in October. If the BOJ is wrong about 2023, it will face more pressure.

            According to a Japanese proverb, in life and politics, an inch ahead lies darkness. The same can now be said of financial markets and BOJ policy.

This is a free link to my WSJ oped.

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Source: for net capital stock, https://www.esri.cao.go.jp/en/sna/stock/stock_top.html; for cash and securities, https://www.mof.go.jp/english/pri/reference/ssc/historical/all.xls

In Part I of this series, we detailed that the Kishida administration is debating a hike in corporate taxes as a means to finance a doubling of defense spending from 1% of GDP to 2% over the coming five years. Since corporate tax revenue has averaged 3.8% of GDP during the pre-Covid period of 2015-2019, a 1 percentage point hike in revenue would require a 25% in tax rates. The issue is currently being discussed by the Ministry of Finance Tax Bureau and the Liberal Democratic Party Tax Commission and a decision is expected around mid-December. As of this date, the outcome is uncertain.

            The Ministry of Economy, Trade, and Industry (METI) is making the defeat of this hike its “top priority,” according to a senior METI official. That creates concern over what METI will “horse trade” in order to achieve that goal. METI is the chief Ministry charged with coming up with tax breaks that would help promote more startups in line with the Kishida administration’s “new capitalism” agenda. These need to be negotiated with the MOF, which is always loath to accept any tax cut while the country runs a big deficit. Out of the half-dozen or so major tax revisions needed to really propel startups, conversations with policymakers in assorted government entities suggest that only a couple are really on the table: some sort of better tax break for business “angels,” those who invest in the earliest stages of new companies, and an improvement in the tax treatment of stock options, which would help companies attract talented employees. Other vital measures remain off the table, and it is unclear how much will be done even regarding those two. (For details on the substance and importance of these measures, see this article.) There’s a risk that, in return for a rejection of the hike in corporate income taxes, METI will concede on the pro-startup measures.

            It’s also unclear how strongly the Prime Minister’s Office (Kantei) is going to push the corporate tax hike. While raising corporate taxes would help fulfill Kishida’s goal of better income distribution between corporations and households, the Kantei is not arguing for the corporate tax hike on these grounds. Rather, it is only saying the hike is needed to finance the hike in defense spending. Perhaps that is the more effective tactic. What remains in question is whether the Kantei will really insist on its agenda, as some past Prime Ministers have done, or whether it will leave it to the Ministries and LDP Tax Commission to hash out. Playing a more passive role has been Kishida’s style so far and the plunge in his approval ratings to just 33% means he has less political capital. Although there is no obvious replacement for Kishida, nor yet a campaign to seek his removal, Prime Ministers whose approval falls below 30% don’t tend to last very long. Even if they survive, their clout to push new initiatives tends to diminish.

            On Nov. 22nd, a panel of defense and foreign policy experts appointed by Kishida issued recommendations on how to build up its defense capabilities and to pay for them. On the latter, it simply stated, “Recognizing that the entire nation must cooperate in this, it is necessary to win public understanding with a range of tax measures that spread the burden,” without specifying which taxes. But the language seemed to imply that Japan should not rely solely on any one tax hike, such as the corporate tax.

The LDP’s coalition ally, the Komeito, has said that tax hikes are its least preferred option for funding the increase in defense spending, Some LDP Diet members of a joint committee with the Komeito on security matters called the expert panel’s call for a tax hike “abrupt.”

Nor is there any consensus among the public. In a Nikkei poll, 34% of respondents said a hike in defense spending should be funded by cutting other spending, 15% said the government should increase its debt, and only 9% favored a tax increase. 40% gave no answer.

Where Goes The Fallow Cash

As noted in Part 1, Japan corporations have no need of low taxes since they cannot even productively invest the money that they already rake in. Nor are they raising real wages. Every year, Japan’s 2 million corporations’ cash flow exceeds its investment in new plant and equipment by about 5-6% of GDP. In fact, since the year 2000, the real (i.e., price-adjusted) net capital stock (factories, offices, stores, and equipment) of Japan’s corporations has increased by a barely visible 7%, but their cash and securities almost tripled (see chart at the top).

            As a result, their stash of financial assets has soared from just 25-30% of GDP back in the early 1980s to 115% as of 2021 (see chart).

Today, 37% of the cash and securities consists of corporations’ investments in their own overseas affiliates, known as outward Foreign Direct Investment. That is a productive use of capital, assuming it’s invested well. However, it still leaves pure paper investments at more than 70% of GDP.

Source: FDI data at https://www.mof.go.jp/policy/international_policy/reference/iip/6IIP.xls

Coming in Part III: the interplay between corporate excess savings and chronic government deficits.

Source: Statistic Bureau at https://www.e-stat.go.jp/en/stat-search/file-download?statInfId=000032103932&fileKind=1

“October Inflation At A 40-Year High” read the headlines. If this really were representative of overall inflation trends, it would put additional pressure on the Bank of Japan (BOJ) to raise interest rates in order to slow an overheating economy. But it reminds me of the line from the movie Absence of Malice: accurate but not true.

            For one thing, this figure refers to the Bank of Japan’s traditional measure of “core” inflation, which comprises all items except fresh food. However, if we use other countries’ measures—all items except energy and all food—then core inflation is at less than half that pace: 1.5% (see the comparison in the chart above). Core inflation is meant to show long-term trends by stripping out items whose prices gyrate up and down a great deal in response to relatively small changes in supply and demand, import prices, etc. The BOJ’s measure of the core, however, includes such items.

            Secondly, such year-to-year comparisons can sometimes be misleading when applied to products with price volatility. A dip in prices in one year before may lead to the appearance of a big rise in the following year, when all that is happening is getting back to a previous level. For example, the price of all items except for all food and energy is no higher today than it was almost three years ago in January 2020. Consequently, even the 1.5% year-on-year comparison for the latter measure of core inflation gives a false impression of the underlying trend and is not, therefore, a reliable harbinger of the future (see chart below).

Source: Statistics Bureau at https://www.e-stat.go.jp/en/stat-search/files?page=1&layout=datalist&toukei=00200573&tstat=000001084976&cycle=0&tclass1=000001085995&tclass2=000001085936&tclass3=000001085996&tclass4=000001085976&tclass5val=0

            Nothing has changed from the previous situation: virtually all of Japan’s inflation in the past three years is due to price hikes in import-dominated items: food, energy, clothing, and footwear. Prices of the latter are rising partly due to higher inflation rates overseas and partly due to the weakening of the yen, which raises the price of imports in yen terms. The rest of the consumer basket has shown virtually no hike in prices (see chart below).

            It’s certainly possible that, if imported inflation continues long enough, inflation could spread throughout the economy. So far, however, that has not happened. Hence, nothing in the latest data is likely to provoke any change in the BOJ’s monetary stance.

The BOJ has been counting on wage hikes induced by a labor shortage to lead to healthy, domestically-created inflation of 2%, realizing that monetary policy alone cannot achieve its 2% inflation goal. It is said to believe that the reason is that, with more women and retirees entering the labor force, the shortage was not as great as superficial statistics seemed to show. Now, the BOJ is cautiously hopeful that the tide has turned, and points to the demand by the chief labor union federation, Rengo, for a 5% wage hike in next year’s “spring offensive” at the large companies. That is its largest request in 28 years and is, in part, a response to current inflation. However, Rengo is not likely to succeed. Keep in mind that it has asked for 4% each year since 2016 and failed to come close. Moreover, even if Rengo succeeded, this would help only a small share of the workforce. Finally, with the US and Europe expected to suffer recessions, even cash-rich companies will resist such a large hike.

One final note. A reader of this post wrote to me: “Do you go food shopping in Japan? This statistical nuance has little to do with not just the perceptions of ordinary people, but with the ability of many people in all but the wealthiest classes to feed themselves — particularly the elderly and the working poor…This sort of argument is rather detached from real life.”

Here is my answer: I take this point and agree with it. The measure of inflation that you use depends on what you are trying to measure. If you are trying to measure the pain to the population, including real, i.e. price-adjusted income, then you measure total inflation. If, however, you are trying to measure underlying trends to see how long inflation is going to stay high, then you need to eliminate highly volatile items. Otherwise, you might think inflation is too high and slow the economy unnecessarily, or you might think it's too low and add stimulus which could worsen inflation down the road.

You also want to know the cause of inflation. If inflation is caused by excess domestic demand, then raising interest rates could help by slowing the economy and reducing the excess demand. If your inflation is mostly imported, raising interest rates will further slow down an already weakened economy.

Finally, while inflation causes pain, so does the cure for inflation: higher interest rates that raise unemployment. Judging what's the best trade-off at any given level of inflation in a world of uncertainty is not easy.

This video (URL at the bottom) presents a panel discussion on the yen, Japan’s competitiveness and growth potential, and Bank of Japan policy, It was held at the Foreign Correspondents Club of Japan (FCCJ) on November 11th. The other panelist, Hiromichi Shirakawa, Japan Chief Economist at Credit Suisse Securities, and I were pretty much on the same wavelength. Here’s the gist of my presentation:

            In the short term, Tokyo has no good options to deal with the yen’s weakness. That’s because, in the last year and a half, the single biggest factor in the yen’s weakness has been the gap between American and Japanese interest rates. As we all saw yesterday, when the ¥/$ strengthened from ¥146 to ¥139, American inflation figures, and consequent interest rates, have more impact on the yen than anything the Bank of Japan (BOJ) can do (see chart below).

Source: Federal Reserve, Wall Street Journal

            While there are calls for the Bank of Japan (BOJ) to raise interest rates, a quarter-century of near-zero interest rates has turned Japan into a low-interest-rate addict. With 16% of all loans charging interest of less than 0.25% and 70% less than 1%, a host of companies would suddenly become insolvent if forced to pay substantially higher rates. Currently, the economy is too fragile to raise rates enough to make much of a dent in the current gap of 3.5 to 4 percentage points.

Weak Yen Reflects Weakened Competitiveness

More importantly, the yen’s historic low reflects, not just differences in monetary policy, but a dramatic deterioration of Japan’s real competitiveness. Here’s the evidence for that:

            Firstly, the “real” yen is weaker than it has been in a half-century, at the dawn of the floating currency rate system. (The real yen adjusts the rate of the yen against all trading partners and adjusts for the difference in price trends in Japan and other countries. A lower number means a weaker yen. See chart below).

Source: Bank of Japan at https://www.stat-search.boj.or.jp/index_en.html#

            Secondly, at any particular gap in interest rates, the yen is about 20 points weaker today than it would have been 10-to-20 years ago (note the blue downward arrow in the chart below).

 Source: Author calculation based on data from Federal Reserve, Wall Street Journal

Thirdly, even with a weaker yen, Japanese companies still find it hard to compete. Japan used to run regular trade surpluses even when the yen was much stronger than today. But, for more than a decade, Japan has been running chronic trade deficits, even though the real yen was 30% cheaper in the last decade than it was during 1994-2012. In short, Japanese companies are now competing on price, rather than product superiority, and are like a deconditioned person on an accelerating treadmill who has to run ever-faster just to keep up (see chart below).

Source: Cabinet Office at https://www.esri.cao.go.jp/jp/sna/data/data_list/sokuhou/files/2022/qe222_2/tables/gaku-mk2222.csv

            Fourthly, even former superstar industries like electronics now run chronic deficits. Even worse, these companies have trouble competing even when they produce in other countries. Despite a 40% surge of global electronics sales from 2008 to 2020, every one of the Japan’s top ten electronics hardware manufacturers saw its global sales slump during that period. Moreover, from 2010 to 2020, total global sales of all Japanese electronics firms plunged 30%.

            Finally, on average, improvement in Japan’s real (price-adjusted) trade balance has contributed a meager 0.1% to Japan’s real GDP growth per year, an amount equal to a rounding error. That’s no higher than it was when the yen was much stronger (see chart below).

Source: Cabinet Office at https://www.esri.cao.go.jp/jp/sna/data/data_list/sokuhou/files/2022/qe222_2/tables/gaku-jk2222.csv

Weak Yen Makes Japan Even Weaker

The weak yen not only reflects Japan’s economic travails, but it is also adding to them. The BOJ is wrong when it claims a weak yen provides a net benefit. It’s the Goldilocks principle: a currency that is too weak causes as much damage as one that is too strong. While the weak yen is adding little to Japan’s topline GDP growth, it is seriously reducing real wages, consumer purchasing power, and the profitability of small and medium companies, by causing big price hikes in import-intensive food and energy. 90% of the rise in prices over the past 18 months, and in the past decade, has come in food and energy. Prices in the rest of the economy have barely risen (see chart below).

Source: Statistics Bureau at https://www.e-stat.go.jp/en/stat-search/file-download?statInfId=000032103842&fileKind=1

            That kind of inflation transfers income from Japanese households to foreign producers. It also indirectly transfers income from Japanese households to Japan’s multinationals. Here’s how the latter works. Japan’s consumers pay more of their income to foreign producers. Some of that comes back to Japan’s multinationals because they can export more and because their profits on overseas affiliates generate more yen when those profits are repatriated.

            The result of that income transfer is that consumption in 2019 (before Covid) was lower than it was in 2014 and, as of July-Sept. 2022, due to a slow recovery from Covid, it’s even lower

.Source: Cabinet Office at https://www.esri.cao.go.jp/jp/sna/data/data_list/sokuhou/files/2022/qe222_2/tables/gaku-jk2222.csv

What’s The Solution?

What is required are reforms that improve Japan’s underlying efficiency, once more making Japanese firms competitive on the global market.

            Perhaps the one bit of good news in this picture is that the yen shock is sounding the alarm. The question is whether policymakers can really hear them and understand what they mean. By the end of the year, the Kishida administration is set to issue a five-year plan that could do a lot to improve the situation if lofty goals about income distribution and nurturing startups are turned into concrete policies. Unfortunately, recent conversations with policymakers in Tokyo suggest that, while a few of the necessary positive steps will be taken, they will not be nearly enough to turn the ship around.

           Here’s a video of the discussion. (It seems to start in the middle, so move the cursor to the beginning.)

Source: Bank of Japan

This audio (URL at the bottom) presents a debate sponsored by Econvue between John Greenwood and myself on why Japan’s interest rates have been so low for so long and why deflation and low inflation have been so persistent. Greenwood’s view is classic monetarism: that inflation is always a function of growth in the money supply, that a central bank can expand the money supply, and thus inflation, as much as it wants to. If the Bank of Japan has not achieved its target, that’s only because it has not created enough money. Hence, while virtually zero interest rates for a quarter century make it look as if the Bank of Japan’s (BOJ) monetary policy is loose, it is actually tight.

Why Central Banks Abandoned Money Supply Targeting

I thoroughly disagree with his stance and do central banks. To my knowledge, there is not a single major central bank that any longer makes money supply its operational target. That’s because it no longer works. As explained in an IMF piece, “Many central banks [used to target] the growth of money supply to control inflation. This approach works if the central bank can control the money supply reasonably well and if money growth is stably related to inflation over time [emphasis added—rk]. Ultimately, monetary targeting had limited success because the demand for money became unstable—often because of innovations in the financial markets.” The US abandoned money supply targeting three decades ago. As the New York Times reported, “Alan Greenspan, the central bank's chairman, said the Federal Reserve would stop relying on growth in the money supply—its traditional tool—and begin relying on interest rates...In an appearance before the Senate Banking Committee today, Mr. Greenspan said the central bank was jettisoning the money supply approach because changes in the way Americans invest their money meant it could no longer predict how much economic growth would be produced by a certain amount of growth in the money supply. ‘The relationship has completely broken down,’ Mr. Greenspan said.”

            Even Milton Friedman, who once declaimed, “Monetary policy is not about interest rates; it is about the growth of the quantity of money,” publicly acknowledged the failure of his most famous doctrine a few years before his death in 2006. Friedman admitted, “The use of quantity of money as a target has not been a success…I’m not sure I would as of today push it as hard as I once did.”

Why The Linkage Broke Down In Japan

In Japan, the linkage between money growth and inflation seemed to work in textbook fashion up until the mid-1990s. Then, as the charts here show, it broke down. This is one of the main reasons the BOJ has had trouble creating sustainable inflation and has felt the need to keep interest rates at near zero for more than a quarter century. 

Greenwood assumes a central bank can hike the money supply as much as it wants and that money supply growth will create the inflation and nominal GDP growth it seeks. That’s not correct. Money supply refers to bank reserves and deposits in the banks by companies and consumers. While we call it money supply, we could just as accurately call it money demand. Just as automakers cannot sell 10 million cars for $30,000 each if consumers don’t wish to buy that many at that price, the same is true of the money supply. No central bank can cause the money supply to grow, say 5% per year, if consumers and companies are not borrowing from the banks, spending the money on various goods and services, and making deposits. Moreover, even if the money supply does grow, its impact on nominal GDP (real GDP plus inflation) also depends on consumer and company behavior. Demand for goods and services is low in Japan and that’s caused by problems that no amount of money-creation by the BOJ can overcome. Yes, a correct monetary policy is necessary, but it’s not sufficient.

            A look at how monetary policy works will make it clear why Japan’s circumstances made BOJ actions less potent. A central bank buys securities, like Japan Government Bonds (JGBs) from banks or other holders. The cash this injects into the financial system is called the “monetary base.” But if that cash just stays in the banks, little happens to the money supply. It is the process of borrowing, spending, and new bank deposits by companies and consumers that multiplies the monetary base into the broader money supply and then into growth in nominal GDP. Before 1997, for each yen of growth in the monetary base, the money supply grew approximately 10 yen and so did nominal GDP.

            Because of slack real demand in Japan, that relationship broke down around 1997 and did so more severely than in other rich countries. Before 1997, the monetary base, money supply, and nominal GDP all grew in proportion. But then the linkage collapsed. Since 1997, the BOJ has multiplied the monetary base 13-fold. Yet, the money supply increased just 2.25 times. And nominal GDP barely grew at all.

The chart at the top of this post gives a closeup of the delinkage between money supply and GDP. And the chart below adds the monetary base to the picture.

            Bear with me for one more technical point. The money supply includes both the monetary base and all the deposits made by companies and consumers as they buy and sell goods and services. But, if we just look at the latter and exclude the monetary base, we find that the entire rest of the money supply has actually decreased since BOJ Governor Haruhiko Kuroda began his “big bazooka” in 2013. And that’s that reflects a decrease in business and household demand for money. As the expression goes, you can lead a horse to water, but you cannot make it drink.

            Weak demand, not poor monetary policy, is also why interest rates have been near zero for more than a quarter century. If neither businesses nor consumers want or need to borrow to invest in more plants and equipment, or in buying homes, cars, and appliances, then demand for credit will be less than the available supply of savings. As a result, interest rates will fall to the floor. Today, more than a third of all loans charge less than 0.5% interest, and about 16% charge less than 0.25%! One wonders if that’s even enough to pay the cost of tracking these transactions. So, the real question is why the demand for goods and services has been so weak for so long.

Why Aggregate Demand Is So Low

Median real (i.e. price-adjusted) household income has been falling since the mid-1990s due to wage austerity, hikes in the consumption tax, and cuts in social security (see chart below). As a result, consumer spending today is no higher today than it was in 2014 before the first of the two consumption tax hikes in the past decade. And that was true in 2019, even before Covid hit.

Source: https://stats.oecd.org/Index.aspx?QueryId=66599#

            With consumer spending so lax and Japan less competitive on the export market, companies feel no need to expand their capacity (factories, offices, stores, equipment, etc.) no matter how low the interest rate. Real capacity today is only 7% higher than it was in the year 2000. As detailed in a recent blog, corporations are raking in cash equal to 15% of GDP, but are investing only 8% of GDP. Instead of investing, companies have used their profits to buy securities, like government bonds, which lie fallow. Why would a car company expand capacity in Japan when domestic sales are falling and they are increasingly meeting overseas markets via overseas factories rather than exports?

            Slack real demand is not a problem that creating money alone can solve. This is when well-designed fiscal stimulus is needed, for example, tax cuts for households, public works to aid decarbonization, etc. And this is when various structural reforms are needed to reverse the last three decades where Tokyo shifted money from households to companies. Kishida has said the latter is what his “new capitalism” is all about, and we’ll have to wait until year’s end to see whether his concrete proposals match his lofty goals.

            To hear the exchange between Greenwood and myself, click on:

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Source: https://www.mof.go.jp/english/pri/reference/ssc/historical/all.xls

Raise Japan’s corporate tax rate? Not so long ago, that would have been unthinkable. On the contrary, for the past few decades, Tokyo has steadily lowered the top rate on corporate income from 52% in 1994 to 30.6% at present (see chart below).

Source: National Tax Agency https://tradingeconomics.com/japan/corporate-tax-rate, OECD https://stats.oecd.org/Index.aspx?DataSetCode=REVJPN

But the government did not get what it paid for: a hike in investment and wages. So, now, the notion of rolling back some of those cuts is being discussed internally by the Kishida administration, the Liberal Democratic Party (LDP) Tax Commission, the Ministry of Finance (MOF), and even the Ministry of Economy, Trade, and Industry (METI). Previously, METI had been the biggest governmental booster of corporate tax cuts, so the mounting disillusionment is quite telling. The MOF, which tends not to like any tax cut, was never supportive but acquiesced in the past, partly in return for hikes in the consumption tax.

(Since I initially posted this, METI has come out firmly against a hike in the corporate tax, despite some dissent on this within the Ministry. This is based on a conversation with a senior official.)

            While a corporate tax hike is now thinkable, it remains to be seen whether it is doable. Still, the fact that this option is even on the table is not only a big shift in governmental thinking but also a sign of the waning power of the big business lobby, Keidanren, on this issue. For a quarter of a century, Keidanren had successfully persuaded the government that, if taxes were lowered, Japanese companies would not only have the money and incentive to invest more, hike wages, and reduced offshoring, but that Japan could attract more foreign companies. As one previously-persuaded, but now chastened, official told me: Keidanren’s forecasts never panned out.

The Trigger Vs. The Cause

The immediate trigger for the rethink is the need to finance a doubling of defense spending from the longstanding limit of 1% of GDP to around 2% over the next five years. That amounts to about ¥5 trillion ($33 billion) each year in extra spending. The head of the LDP Tax Commission, Yoichi Miyazawa, told Nikkei that “If we expect a significant amount of revenue, then we need to consider a significantly large tax,” stressing that relying on bigger deficits would be “so irresponsible.” Miyazawa, it should be noted, is a cousin of current Prime Minister Fumio Kishida, as well as a former MOF official, and a nephew of the late Prime Minister Kiichi Miyazawa.

            Miyazawa stressed that (politically difficult) cuts in spending should come first, but, “If we are still short (of funds), we would have to tap tax revenue.” In a Reuters interview, he added, “I've heard various rumors about tax items, but I haven't made any suggestions...We must consider from scratch, including raising income [on more affluent individuals] and corporate taxes.”

            Unfortunately, Miyazawa ruled out any hike in Japan’s extremely low carbon tax. It is possible but unlikely that Kishida will overrule him on this matter.

            While defense spending is the trigger, the underlying factor is disappointment in the failure of past tax cuts to deliver promised results.  At their November 26 meeting, members of Kishida’s New Capitalism Council were given materials illustrating the degree of failure. Between 2000 and 2020, the combined yearly profits of Japan’s 5,000 thousand largest corporations almost doubled (up ¥18 trillion or $120 billion), but their compensation to workers fell 0.4% and their capital investment fell 5.3%. Nor did the promise of more inward foreign direct investment pan out. So, raising the tax would be in line with Prime Minister Fumio Kishida’s “New Capitalism” agenda. Back in May, an anonymous member of the LDP Tax Commission told Jiji Press, “While we won’t be able to drastically raise [the corporate tax], we need to implement a structural transformation that suits the current situation of Japan.”

Fallow Corporate Cash Follows Weak Shareholder Power

Let’s see how Japan’s mountain of retained earnings arose and how it’s linked to poor corporate governance. The MOF numbers in this post cover Japan’s 1 million incorporated firms, which employ about 35 million people, a bit more than half of Japan’s labor force.

            Current (recurring) corporate profits per year have more than doubled as a share of GDP from 7% in the early 1980s to 15% these days. A similar doubling has occurred in estimated cash flow (which equals half of current profits plus depreciation). However, companies are not plowing this cash back into the economy. Gross investment has stayed at 8% of GDP, the same level as in 1980. In recent years, the gap between cash flow and investment has amounted to about 6% of GDP (see chart at the top).

If Japan’s shareholders in listed companies had more power vis-à-vis management, they could force companies with few profitable investment opportunities to return the excess cash via dividends. In healthy capital markets, it is primarily rapidly-growing companies that pay either no dividends or relatively low ones. That’s because they can provide even greater returns to shareholders by using retained earnings to fund expansion. Later on, as companies mature and their growth slows, they return more of their profits to the shareholders. The latter can then invest in other, newer companies with better growth prospects, which increases national GDP. Or else, they can spend the money as consumers, which also promotes GDP growth. In Japan, even though the First Section of the Tokyo stock exchange is dominated by older, slower-growing companies, payout ratios remain small, despite having increased somewhat in the past couple of decades. The 2012‑2022 average was 36% of net income.

            Imagine what could happen if Japan had more high-dividend stocks and more dividend-oriented mutual funds (investment trusts). In that case, more of the middle class could use the stock market as their piggy bank rather than, as at present, the bank accounts on which they earn negligible interest. Investing to gain dividend income is far less risky than gambling on the prospects for capital gains in a market with a four-decade history of sharp booms and busts. This dividend income would boost consumer spending. (While not all the excess cash is held by listed firms, the 5,000 biggest companies own two-thirds of the excess cash.)

            Japan charges a 20% tax on both capital gains and dividends, a rate higher than the marginal rate on the 70% of Japanese households with an annual income under ¥6.95 million ($63,000 during 2017-21). Tokyo ought to consider a graduated rate on dividends so as to make them a better deal for the middle class, make them lower than the rate on capital gains, and to incentivize companies to pay out their excess profits.

Coming Up in Part II

If companies are neither investing their excess cash, nor raising wages, what are they doing with it? That will be detailed in Part II, as will the consequences of all this for national growth and the budget deficit, as well as a potential remedy.

Bank of Japan (BOJ) Governor Haruhiko Kuroda faces a big dilemma. If domestic demand and inflation were the only considerations, his policy of keeping interest rates at near-zero levels would seem to make perfect sense. However, the side-effect is a steep plunge in the yen’s value. That is a direct result of the growing gap between interest rates in Japan and those in the US and Europe (see chart below). Kuroda asserts there is no dilemma, based on his claim that a yen this weak is still a net benefit for Japan’s economy because it stimulates more experts. But many economists say the costs are greater than the benefits. It is certainly causing more harm than good to Japanese households while forcing the government to hike deficit spending to make up for the loss of consumer purchasing power. Moreover, the boost to exports from a weaker yen is not as powerful as it used to be.

            To begin, let’s briefly review the key points in Part I of this post. Japan’s inflation is very different from that in the US and Europe. Not only is Japan’s inflation rate far lower—just 2.4% headline inflation and 0.4% core inflation—but 88% of it comes from the food and energy sectors that are heavily influenced by global factors beyond the control of the BOJ. Moreover, compared to the US and Europe, most of Japan’s inflation is due to “cost-push” forces rather than “demand-pull.” The latter refers to the excess demand which prevails in the US and to a large extent in Europe. When inflation is a case of demand-pull, the clear solution to demand-pull inflation is for the central bank to reduce excess demand via higher interest rates. By contrast, the supply problems causing cost-push inflation—from rising energy prices to a shortage of semiconductors—can simultaneously raise prices and hamper GDP growth, a phenomenon sometimes called “stagflation.” That’s a far more thorny problem for a central bank to tackle.

            Kuroda argues that the cost-push factors behind Japan’s still-low inflation are temporary. Indeed, the BOJ predicts inflation next year will be lower than this year, at 1.2-to-1.5%. Therefore, says Kuroda, Japan has no reason to raise interest rates; on the contrary, doing so would undermine both GDP growth and the BOJ’s effort to attain healthy demand-led 2.0% inflation.

            The predicament is that Japan is not an island sheltered from outside financial storms. As other countries raise rates and Japan refuses, the result is a mounting gap between interest rates in Japan and those elsewhere. In response, investors shift money from Japan to the US and Europe, and the yen plunges to levels not seen since the financial cataclysm of 1998 (see chart).

Weak Domestic Demand and A Very Weak Yen

By raising prices for essential import-intensive consumer items, like food and energy, a weak yen leaves consumers and domestically-oriented businesses with less money to buy other items, like those produced at home. Paying more for imports transfers income from Japanese consumers to foreign producers as well as to Japan’s multinationals, who make more profits on their exports and foreign assets when the yen is weak. The yen’s price-adjusted purchasing power on the international market for goods and services is the lowest it has been since 1971. It is one of the reasons that consumer spending has been stagnant for the past nine years and, with the additional factors of two hikes in the consumption tax, Covid, and war in Ukraine, is now 4% lower than it averaged nine years ago in 2013 (see chart at the top).

            It’s not just consumer demand that’s weak. Business investment is already down 9% from its 2019 peak, and higher interest rates would add to the headwinds. Moreover, while the official unemployment rate in July was just 2.5%, an additional 3.7% of the labor force was listed as “employed person [but] not at work,” i.e., employees with no tasks who are kept on the payroll with the help of government subsidies.

            So, it’s quite understandable why Kuroda opposes raising interest rates when private domestic demand is so weak and domestically-created inflation remains so low. However, the cost of this policy could be a continued nosedive of the yen, which will further weaken private domestic demand. Currency traders keep going back and forth on the trajectory of the yen based on their estimates of future US inflation and Federal Reserve policy.

Will Speculators Defeat Kuroda?

Because of the tumbling yen, many financial traders believe Kuroda will be forced to let 10-year bond rates rise above 0.25%. Back in June, the BOJ had to spend an unprecedented $80 billion in just one week to defend the 0.25% rate, and there will no doubt be further attempts to force the BOJ’s hand. However, that makes the BOJ even more determined. It worries that, if the markets breach its 0.25% line in the sand, where will it stop? The smart money points out that, for the past 25 years, those who’ve bet against the BOJ’s ability to control interest rates have repeatedly lost truckfuls of money. Those betting against the BOJ retort: past results are no guarantee of future outcomes.

               The good news for Kuroda is that, even though the Fed is raising overnight rates, called Fed funds, such hikes do not move 10-year bond rates to the same degree. That’s because the hike in the Fed Funds is only temporary. In fact, when investors fear that a recession will result from the Fed’s attempt to cool an overheating economy, the market typically goes into a so-called “inversion” in anticipation. That’s a case where the interest rate on 10-year bonds is lower than overnight rates (see chart below).

            Notice in the chart below that today’s 10-year bond rate is actually lower than it was in June, even though the Fed funds rate has been hiked from 1.65% to 2.4%. So, it remains to be seen where the 10-year rate will go when the Fed raises overnight rates yet again at its September 20-21 meeting and if, as expected, continues to raise them at subsequent meetings.

Fasten your seat belts; it’s going to be a bumpy ride, with enough back and forth in the mood of the market to cause whiplash.