Foreign Developed

Will Japan Finally Overcome Deflation?

December 23rd, 2014 | By Nick Sargen


  • With his re-election as Prime Minister, Shinzo Abe will have a second try at jump-starting Japan's flagging economy. The prevailing view among economists is there was progress towards combating deflation in the first term, but the decision to boost the national sales tax by 5% in April wound up weakening the economy.
  • One of the purposes of holding early elections was to lay the groundwork for Abe to postpone a second round of value-added tax (VAT) increases slated for 2015, while the government embarks on a series of structural reforms. However, most economists are skeptical about what will be accomplished on this front.
  • Meanwhile, the Bank of Japan's (BOJ) efforts to expand its balance sheet in the past two months has contributed to a further weakening of the yen, which has now depreciated by nearly 45% against the dollar over the past two years. In my view, this is vital to improving Japan's competitiveness and jump-starting the economy in 2015.
  • My assessment is that the onset of deflation in Japan in the mid-1990s can be traced to an increase in the yen on a real trade-weighted basis of more than 60% over a ten-year period. Consequently, if the BOJ is able to engineer further yen depreciation, the prospects for ending two decades of deflation will be enhanced.

Background on Abenomics

When Shinzo Abe was elected Prime Minister of Japan two years ago, he campaigned on ending two decades of deflation and reviving Japan's economy. The policies he embraced (commonly called "Abenomics") consisted of three "arrows" – monetary reflation, fiscal stimulus (or consolidation), and structural reforms. The first to be implemented was monetary ease via a substantial expansion in the Bank of Japan's balance sheet. This was accompanied by a 25% depreciation of the yen versus the dollar from the beginning of November 2012 to the middle of 2013, which resulted in a modest rise in Japan's consumer price index.

Thereafter, the yen stabilized against the dollar around Y100/$, and the government's attention shifted to fiscal consolidation. Specifically, it sought to reduce Japan's outsized government budget deficit by imposing a 5% increase in the VAT in April. Japanese households responded by accelerating their purchases ahead of the tax hike, and then paring back on spending, which caused real GDP to decline by 7% annualized in the second quarter. While the government was prepared for a temporary decline in the economy, it was forced to reconsider raising the VAT further in 2015, when the economy failed to improve in the third quarter.

Against this backdrop, Prime Minister Abe opted to call an early election in December, in which he campaigned on postponing the second tax hike for several years. With his re-election now secure, he is expected to focus on structural reforms in areas such as corporate taxes, agriculture, social security, and labor. Most observers, however, are unexcited about the prospects for meaningful change in these areas. Therefore, there is considerable skepticism about whether Abenomics will transform Japan's economy.

The BOJ Steps into the Breach

In the meantime, Governor Kuroda of the Bank of Japan announced at the end of October the central bank would take additional action to expand its balance sheet through a program of security purchases. The announcement was undertaken amid signs that Japan's inflation rate had slowed to 1 percent, well below the official target of 2%, and also amid falling oil prices. It caught market participants by surprise and caused the yen to depreciate by more than 15% against the dollar. This move has increased the yen's cumulative depreciation versus the dollar to about 45%.

I consider this to be a very significant development, considering that the onset of deflation in Japan in the mid-1990s has been preceded by a 60%+ increase in the real trade-weighted value of the yen beginning in mid-1985, as U.S. policymakers threatened to impose trade sanctions on Japan if it did not allow the yen to appreciate (Note: This move constituted the largest and most prolonged deviation from purchasing-power-parity of any currency in the era of flexible exchange rates). In order to survive, Japanese businesses kept cost (and wage) increases to a bare minimum while paring back on capital spending and also shifting the locus of manufacturing production to emerging economies in Asia.

One of the principal differences today is that U.S. policymakers wish to see the Japanese economy stronger, even if it takes stronger export growth to get there. While the BOJ's program has failed to lift exports past their peak thus far, Japanese multinationals are benefiting from a cheaper yen as evinced in improving corporate profits and a rising stock market, which currently stands at a five-year high.

Is Further Yen Depreciation Likely?

Considering how far the yen has moved in the past two years, it may be risky to forecast significant further declines. However, I believe this to be essential if Japan is finally able to overcome two decades of inflation. Economists at BCA Research share this view in a recent report titled "Abenomics, Debt and the Nikkei," (November 21, 2014):

  • "As far as Japan is concerned, the recent rise in various price indexes is the direct result of the sharp fall in the Japanese yen since December 2012. It is the relative price shift that has driven up Japan's price levels, not excessive demand.
  • If so, it suggests that the recent rise in inflation rates will not be sustainable. Once the yen stops falling, the natural tendency is for price levels to stop rising and to resettle to new levels. The obvious implication is BOJ Governor Haruhiko Kuroda is serious about sustaining a 2% inflation target, he must manage a continued down drift in the Japanese currency."

On this basis, BCA is forecasting that the USD/JPY could hit 130 next year, and that Kuroda will have to manage an annual 10%-15% depreciation of the yen to sustain a 2% inflation rate based on long-term correlations between the two. My own take is that such an outcome would require the continued acquiescence by U.S. policymakers, and it will also be influenced by oil market developments. Nonetheless, I believe yen depreciation is the only viable strategy today for ending deflation in Japan.