Inflation gains footing in Japan as BOJ ponders future exit

Bloomberg

Inflation is showing signs of taking root in Japan. With price gains halfway to the Bank of Japan’s 2 percent target, domestic demand is picking up after years in which external factors such as energy prices did most of the work.
As the economy continues to grow, this could open the door for the central bank to start adjusting monetary policy as soon as later this year, and put Prime Minister Shinzo Abe in a position to declare victory in Japan’s long battle with deflation.
“A rebound in domestic demand will have a major impact on prices this fiscal year,” said Takeshi Minami, chief economist at Norinchukin Research Institute.
Optimists point to the output gap, a key measure of supply and demand in the economy. It shows demand pressures are at the highest level since 2007. With the economy still growing, a chronic labour shortage is also expected to keep driving modest wage gains, in turn supporting consumption and pressuring companies to raise prices. Capital investment has risen for five straight quarters through to the end of 2017.
Few economists expect Japan’s core inflation gauge to hit 2 percent. And external factors remain key risks. A sharply stronger currency, falling oil prices or an escalation of global trade tensions could quickly stymie the BOJ once again.
Yet the central bank doesn’t need inflation to hit 2 percent to begin tweaking its policy framework, particularly if growth remains firm and global interest rates move higher, they say. Anchoring core inflation — which excludes fresh food — at around 1 percent may be enough for the BOJ to act.
“As long as there’s no risk that deflation will return, which the BOJ wants to ensure by any means, I don’t think the BOJ cares whether inflation is rising by 1 percent or 2 percent,” said Shinichiro Kobayashi, an economist at Mitsubishi UFJ Research & Consulting.
Kobayashi doubts that 2 percent can be reached, but says progress is being made and there is little risk now that Japan will return to deflation.
The International Monetary Fund also foresees an upward trajectory. Japan’s headline inflation measure is expected to rise to 1.1 percent this year and in 2019, from 0.5 percent in 2017, the IMF said in its World Economic Outlook. It cited strong domestic demand as well as higher energy and food prices.
There could be soft patch coming in the short term, though. Economists say the government will report on Friday that Japan’s core inflation registered 0.9 percent in March from a year earlier, down from 1 percent in February.
Inflation excluding fresh food and energy will have to rise above 1 percent and the dollar will need to be above 110 yen for the BOJ to adjust its policy, according to Takuji Aida, chief Japan economist at Societe Generale SA.
The BOJ won’t truly exit stimulus until 2 percent is achieved, said Aida, who believes the central bank will eventually meet the target. “They may tweak current policy to contain its side effects and make it sustainable,” he said.
Abe, whose support rate is falling due to a series of scandals, may declare victory over deflation if he wins his party leadership race in September, according to Yuki Masujima of Bloomberg Economics.
“Declaring the end of deflation would say that Abe’s policies are going well and he won’t rely too much on additional fiscal spending or monetary easing,” said Masujima, who added that the BOJ could then adjust its policy in October. “It would mean the government gives the BOJ an okay to raise the long-term rate a bit.”