Albert Edwards: Deflation Smaller Risk than Inflation in Japan

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Albert Edwards, Societe Generale’s bearish strategist, is out with a new report on Japan below is an excerpt.

There is a large body of highly respected commentators who dismiss the notion that Japan is bust. My friend, former colleague and Japan guru, Peter Tasker is certainly one of them. In a recent FT article Tasker highlighted Japan’s “structural excess of savings and net overseas financial assets equivalent to more than 50% of GDP” – link. He is worried though that the rise in the consumption tax is a policy error because the economy is simply not strong enough at this stage to shrug off such a fiscal hit equivalent to 1.7% of GDP.

Our own economist’s views are similar – even with the likely ¥5tr stimulus package to offset the impact of the consumption tax hike. Tasker points out that since a sizable stimulus had already been implemented this year, another of a similar size will be required just to avoid, ceteris paribus, a GDP contraction (no wonder Japan’s public sector deficit is still almost 10% of GDP in 2013!). Our own economists believe that at the current(ish) ¥/$100 exchange rate, GDP will stagnate next year with the announced mix of policy. Hence both they and Tasker expect more QE from the BoJ to be required and in the process a decline in the Yen to ¥/$110 should sustain growth at a meagre 1% next year.

In my view we are quickening the pace towards losing control of both the Japanese currency and inflation. We reiterate our view that any decline in the yen at this time will echo the 1996/7 period where yen weakness put a severe strain on other Asian countries balance of payments and contributed in large part to the 1997 Asian currency crisis. I expect yen weakness over the next year to begin accelerating out of control as BoJ QE is stepped up, forcing widespread devaluations in the EM world, including China. The impact of this on the West is not rocket science. There have only been two occasions when US implied inflation expectations have turned negative – 2008 in The Great Recession and 1998 in the wake of the Asian crisis.

Japan’s rapidly aging population

In our view, Japan’s rapidly aging population has undermined their surplus savings story. The recent surge in retirees means that Japan’s public pension fund (the world’s largest scheme) turned a net seller of JGB’s in 2012 – link. However they choose to dress it up, the reality is the Japanese authorities simply had no option but to resort to the printing press to fund continued gargantuan public sector deficits of almost 10% of GDP. But even QE fans have certainly been surprised at the extent of the BoJ’s shock and awe $75bn a month QE programme (i.e. almost as large as the US QE3 while Japan’s economy is a third of the size!).

Personally, I’m not quite sure about the fiscal logic of offsetting the impact of the rise in the consumption tax with further fiscal stimulus – giving back with one hand what you have just taken away with the other – but there’s quite a lot going in the markets nowadays that I find pretty perplexing. However, I am a bit more relaxed than many other commentators about the impact of the consumption tax hike on Japan in its quest to exit deflation. Why?

The recently published Japanese Tankan survey of companies showed a sharp acceleration of the trend towards labour shortages. Although this may be surprising given Japan’s anaemic economy over the last decade, it is another consequence of the rapidly aging population. The product market is still loose but the labour market is not (see chart below).

Japanese Tankan shows labour market tight and getting tighter


The consequence of this is pretty straightforward. We should expect to see a tight labour market resulting in an acceleration of wages. The first signs of this have just started to appear in recent data (see chart below). Indeed higher nominal wage inflation has been cited by PM Abe as an essential component to exiting deflation.

Japanese wage inflation and Tankan labour market tightness (latter inverted)


Japan’s consumption tax hike

Most commentators believe that Japan’s consumption tax hike, despite boosting headline inflation, will prove to be a deflationary underlying impulse for the economy. In that sense, its economic impact is similar to a rise in the oil price. Our own economists expect Japan’s headline CPI inflation to rise in excess of 3% in the aftermath of the rate rise next April.

The key to the success in PM Abe’s attempts to exit deflation is to increase inflation expectations. That lowers the expected real interest rate and encourages borrowing and spending. We have to look no further to how the US and UK authorities continuously attempt to inflate house prices in an attempt to lower the real interest rate on these purchases and encourage borrowing and spending.

Japan has been in deflation for so long

Inflation expectations are a funny thing, and given Japan has been in deflation for so long, reversing economic agents’ entrenched expectations of deflation will be difficult. Yet a rise in the CPI headline rate of inflation (albeit for the ‘wrong’ reasons), juxtaposed with rising wage inflation and a sliding yen may well produce a change in perceptions of inflation. It will begin to feel like a more inflationary economy, especially now commercial and residential land prices have also begun to rise again in the 6 big cities.

On this subject of inflation expectations, the recent experience of the US may be significant and hopeful for PM Abe. Since US QE started, ‘one year ahead’ inflation expectations, as measured by the Michigan Survey, have risen ahead of expectations prior to the 2008 Great Recession. Also it is unusual how inflation expectations have also run well in excess of actual headline CPI inflation since QE started in the US (see chart below). The mean rate of expectations has consistently held above 4% in recent years and the median above 3% despite headline inflation consistently tracking between 1-2%. To some extent this may be an indication that QE has been successful in the US in lowering the real interest rate that economic agents expect to be paying. This may help in reviving borrowing and spending (of course this ignores the actual reality that the US is flirting with outright deflation!).

US Michigan Survey ‘one year ahead’ inflation expectations well ahead of actual CPI inflation

CPI inflation

So I am thinking that the hike in the consumption tax in Japan may play a role in shifting inflation expectations higher when juxtaposed with the BoJ moving to QE2, a sliding yen, rising wage inflation and rising property prices. The beneficial impact that PM Abe is looking for may well offset the deflationary impact on the economy. And if we get a lift-off in Japanese inflation via a wage/price spiral, the future for the world’s financial markets will look very different from what we have become used to over the last 20 years.

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