28 March 2017
Since the BoJ introduced its 2% inflation target, it has dedicated huge policy energy and resource to fulfilling its mandate. However, the latest core CPI rate was just 0.1% year-on-year having averaged -0.3% in 2016. Admittedly this woeful outcome reflects temporary shocks related to energy prices and a period of yen strength in 2016, but as these effects fade, the prospects of a material shift towards 2% remain distant. On our forecast, inflation is likely to reach 1% by the end of the year before stabilising close to that level within our investment horizon. This has resulted in a major gap emerging between the market and the BoJ’s forecasts (see Chart 6). What is the risk that the market is wrong and the Bank will be able to fulfil its mandate?
There are three potential scenarios in which inflation could reach 2%. First, is through a shock to import prices, either derived through a weaker currency or higher energy prices. In terms of the former, it is clear an inflationary impulse is already in train given the currency is close to 10% below the level it was prior to US election. However, to reach 2% we would need USD/JPY to depreciate beyond 140 yen. Our central scenario is for the yen to stay range bound, with an acceleration of the recent reversal a more likely outcome. For energy prices to contribute still more than the 0.3-0.4 ppts we have pencilled in to core CPI measures in the second half, we would need a sustained rally in oil prices. In reality, Brent crude has dropped nearly 10% over the last month. Even if this were to reverse, the magnitude of the oil-price shock would need to be closer to 40% for it to push inflation to 2%, and even then it would probably need to be accompanied by a material depreciation of the yen.
A second scenario is based on a rise in inflation expectations, either due to the Bank’s commitment to its 2% target or through higher perceived prices rises. The Tankan Survey, consumer price outlook and Opinion Survey of General Public Views all point to declining inflation expectations in recent years – with little apparent impact on the credibility of the target from the ‘overshooting commitment’ introduced in September. With regards to the latter, measures of point of sale prices, which provide an insight into households’ actual price experience, dropped noticeably at the beginning of 2016 and have stagnated at low levels. Furthermore, CPI service prices, which are historically more closely associated with the business cycle, have been declining persistently since peaking in 2014.
A final scenario relates to a pick-up inflation consistent with higher growth expectations of firms and households. Significant emphasis has been placed on raising the country’s growth potential. In reality, the government reform agenda has failed to revive the outlook for the economy. Unsurprisingly, base pay growth has remained anaemic (see Chart 7). Looking ahead, the inflexibilities of Japan’s labour market might actually prove a boon to policymakers, as a technical rebound in inflation in 2017 may provide a higher CPI-based portion for base hikes in the 2018 Shunto negotiations.
Govinda Finn, Senior Japan Analyst