Inflation: Japan Stands Alone, Part I

The BOJ’s Dilemma on Interest Rates and the Yen

Just as cancer of the lung and of the liver are different illnesses, so are the bouts of inflation hitting Japan, the US, and Europe. Different maladies require different remedies and, as will be detailed in Part II, Japan’s variant is creating a big dilemma for Bank of Japan (BOJ) Governor Haruhiko Kuroda.

            It’s not just that Japan’s headline inflation is far below that in the US and Europe—just 2.2% in Japan during April-July 2022 vs. 8.6% in the US and 8.1% in the 19 Eurozone countries. In addition, the source of inflation is different. An overwhelming 88% of Japan’s inflation stems from the volatile import-intensive food and energy categories, even though these items make up only 27% of consumer spending. All the remaining items—known as “core” inflation—account for a paltry 12%, far below the 61% share in the US. The Eurozone stands in the middle at 32% (see chart above).

Food & Energy Versus Core Inflation

Central bankers focus on core inflation because it is a better predictor of longer-term trends. By contrast, food and energy fluctuate a great deal in response to global events outside a nation’s control, from pandemics to war to fluctuations in China’s growth. Their prices can drop even when core prices rise. As seen in the chart below, inflation trends in the food and energy sectors are very similar in Japan, the US, and Europe.

            Consequently, most of the disparity in headline inflation among Japan, the US, and the Eurozone stems from core inflation, where domestic supply and demand conditions play a stronger role. Japan’s core inflation as of July was just 0.4%, far below the BOJ’s 2% goal. By contrast, core inflation has soared to 6% in the US and has reached 4% in the Eurozone (see chart below).

            This is a major reason why Kuroda sees Japan’s inflation as transitory and insists on continuing the BOJ’s near-zero interest rate policy. In its July Outlook report, the BOJ predicted that consumer prices (aside from fresh food) would rise 2.2-to-2.4% in the current fiscal year, which ends next March. Then, predicted the BOJ, inflation would fall back to 1.2-to-1.5% in fiscal 2023, a level still below its 2% goal. By contrast, central banks in the US and Europe fear that, unless they aggressively tamp down inflation momentum now, it could become self-feeding and rise to even higher levels.

Demand-Pull Vs. Cost-Push

The other key distinction central bankers make is between “demand-pull” and “cost-push” sources of inflation. The two variants require different policy responses. The concentration of Japan’s inflation in food and energy suggests that global cost-push forces dominate Japan’s inflation. In the US, domestic demand-pull forces are stronger than cost-push, and in Europe, the two causes are more equally balanced.

            Demand-pull means that aggregate demand is rising faster than the economy’s ability to meet that demand (i.e., aggregate supply), i.e., the economy is “overheating.” For a while, the economy will grow faster than is sustainable, sending prices higher. Steady 2% inflation is regarded as optimal; core inflation substantially above that reflects overheating. In the US, for example, the government handed out immense sums of cash to households to head off a deep recession during the mass layoffs provoked by Covid. However, much of that money was saved because people could not access all sorts of services. Now, that cash and pent-up desires are feeding excess demand.

            The remedy is to slow demand by raising interest rates in order to restore the balance between demand and supply. Unfortunately, it’s hard to execute this slowdown without pushing the economy into recession. The higher and more protracted the inflation, the greater the difficulty of a soft landing. That’s why central banks like to hit the brakes hard before trends get out of hand. Getting the timing and severity right is more art than science.

            Cost-push means that the prices of important inputs like energy or steel have risen, or they are harder to get, e.g., the semiconductor shortage that is hampering auto production or Russia’s cutoff of oil and gas to Europe. As a result, prices can climb even as the GDP slows or even falls, a combination nicknamed“stagflation.” In both Europe and the US, supply chain problems caused by Covid account for about a quarter of core inflation. Another quarter stems from people suddenly being able to buy services that they could not buy before.

            Dealing with cost-push inflation is more complicated. Suppose prices of vital inputs shoot up 10% in a one-shot event, but they do not keep rising year after year. If so, the central banks can wait until things return to normal. Initially, the US Federal Reserve and the European Central Bank thought that was the current case. The BOJ believes that’s still the case in Japan. If, however, cost-push pressures keep sending inflation rates upward rates over a prolonged period, people could change their behavior in response. Workers who expect inflation to last could demand higher wages. Companies could succeed in passing on higher costs to their customers. So far, there is little evidence of such a spiral. Wages are growing far more slowly than prices. Nor is there any surge in expected of inflation over the coming five years by either consumers or financial markets in the US or Europe.

            What is clear is that supply chain shocks caused by Covid, the war in Ukraine, and, for Japan, the weakening yen, are causing a lasting episode of cost-push inflation. How prolonged remains to be seen. This is a tougher problem to address. How much, for example, does the ECB want to slow demand in an economy where GDP is expected to decline due to Russia’s cutoff of oil and gas?

            In Part II, we’ll address how the renewed downward pressure on the yen caused by these inflation discrepancies is creating a big dilemma for the BOJ’s interest rate policy.