Japan Finally Overcomes Deflation

In the realm of global economics, few countries have had as tumultuous and prolonged a journey through economic stagnation and deflation as Japan. For an extended period comprising nearly three decades, Japan was ensnared in the grips of deflationary pressures, prompting the Bank of Japan (BoJ) to adopt an unprecedentedly lax monetary policy, culminating in a 25-year stretch of near-zero interest rates and an eight-year stint of negative interest rates. Now, as Japan emerges from this 'lost thirty years,' the changing economic landscape offers a glimpse into a more hopeful future.

Beginning in April 2022, Japan's core consumer price index (CPI), which excludes volatile food prices, has consistently surpassed the BoJ's target of 2%. This is a remarkable shift in consumer pricing trends that has led many economists and market participants to declare that the country has finally managed to escape the long-term deflationary trap. In terms of economic growth, the data tells a rather encouraging story as well: Japan's real GDP saw a year-on-year increase of 1.9% in 2023, with nominal growth at 5.7%—outpacing China’s nominal growth for the same year. This surge indicates that Japan's economy is gradually regaining its footing.

Advertisement

As the country’s economic indicators show signs of recovery, the BoJ conducted a significant policy reassessment, raising the policy interest rate from a negative 0.1% to a neutral 0.1% in March 2024, and later, at the end of July, to 0.25%. These adjustments signal the start of the normalization process for Japan's monetary policy, marking a drastic departure from the central bank's long-standing stance that had strayed so far into the realm of accommodation.

One must ponder upon the implications of this policy shift: Will Japan’s transition from negative rates to a normalized monetary policy be smooth? The answer is not straightforward, as the implications of such a significant monetary shift can reverberate through both local and global markets.

For a modern central bank, a key requisite before enacting an interest rate hike is a sustainable level of inflation. The BoJ has aimed for a core inflation rate hovering around 2%. Recent statistics show that Japan’s core CPI has stabilized around 2.5% in 2024, marking a substantial improvement. One of the more positive aspects contributing to this stabilization is the increase in nominal wages, which rose by approximately 5%. This adjustment, when adjusted for inflation, has resulted in a renewal of real wage growth, fostering an environment that encourages a constructive wage-price spiral—an ideal scenario for supporting inflation expectations.

However, the BoJ's projections reveal a more cautious outlook: they anticipate a decline in core inflation down to 2.0% by 2025, contrasting with broader market expectations. Given Japan's extensive history of deflation, it is perhaps understandable for policymakers to take a conservative approach to future inflation forecasts. After all, much of their professional lives have been spent wrestling with policies aimed at escaping the grip of deflation; thus, the sudden arrival of inflation can feel like a surreal twist in their economic narrative.

Apart from inflation metrics, economic growth must also return to potential levels before aggressive tightening can truly be considered. Geopolitical factors, capital movements, and restructuring of global supply chains have contributed to Japan's recent economic resurgence. Projections from the BoJ suggest a modest GDP growth rate of 0.6% for 2024, with gradual increases towards 1.0% in subsequent years, placing the economy near a potential growth level estimated at between 0.5% and 1.0%.

If Japan's core inflation stabilizes around 2% and economic activity aligns with desired growth levels, the next logical step in the normalization of monetary policy involves returning policy interest rates to what is referred to as the natural or neutral rate of interest. Academic consensus generally estimates Japan's natural interest rate to fall between 0% and 0.5%. Currently, the yield on Japan’s ten-year government bonds stands at about 1%, while inflation expectations hover around 2%. This creates a scenario where real yields remain negative. It seems plausible that Japan's neutral policy rate may need to rise to around 1% to effectively mitigate the persistent real yield gap in long-term government bonds, establishing a likely ceiling for further rate hikes.

Taking into account Japan's structural inflationary challenges, the pathway for increasing the policy interest rate from its current level of 0.25% to about 1% is unlikely to be without its hurdles. It's plausible that the tightening cycle might stall around the 0.75% mark. Factors influencing this course include the residual impact of domestic inflation as well as pressures from external markets, particularly the U.S. monetary policy landscape.

When cast against the evolving global backdrop of monetary policies, the dynamics between the U.S. and Japan are proving to diverge markedly. The prospect of rising interest rates in Japan may occur concomitantly with falling rates in the U.S. This divergence is noteworthy as it heralds important changes in the macroeconomic landscape. Primarily, a narrowing of interest rates between Japan and the U.S. is expected. Over the last two years, the yield spread on ten-year government bonds between these two economies has typically fluctuated between 300 and 400 basis points. As the U.S. enters a period of rate cuts and Japan begins to raise rates, this historical spread is likely to contract significantly, potentially returning to levels seen prior to the pandemic.

Additionally, Japan's decision to raise interest rates may set the stage for a strengthening yen against the dollar. Immediately following the COVID-19 pandemic, the widening yield gap, largely a product of aggressive rate hikes by the Federal Reserve, had seen the yen depreciate substantially against the dollar, falling from an exchange rate of 110 yen per dollar pre-pandemic to 145 yen post-pandemic. With Japan’s recent hikes, the yen may very well be poised for appreciation as interest rates converge toward pre-pandemic levels.

Should the yen strengthen against the dollar, the nation's export prices could rise while import prices would fall, thus alleviating the transitory inflationary pressures. Consequently, the core CPI might dip below the crucial 2% mark, impacting the BoJ's future policy direction.

This situation paints a vivid picture of the complexities involved in Japan's monetary policy normalization process, particularly as the nation wrestles with demographic challenges such as a declining workforce and increasing aging population. High reliance on domestic consumption to achieve inflation targets through wage-price dynamics appears increasingly daunting.

Moreover, Japan's monetary normalization has broader implications for global finance—especially the rise of carry trades. Such investment vehicles leverage low-interest currencies like the yen to invest in higher-yielding assets elsewhere. The prevalent carry trade has been a key driver in foreign exchange markets, with investors borrowing in yen to capitalize on the spread between low yields and higher returns from other markets. For instance, one might recall a scenario where an investor borrowed yen at low rates to invest in U.S. Treasury bonds, yielding a staggering profit margin that epitomizes the attractiveness of such strategies.

Estimating the scale of yen-based carry trade activities is no easy feat. Nonetheless, it is evident that the yen not only plays a significant role in the global forex markets but also tends to be a currency of choice for speculative trades, often exceeding Japan’s nominal GDP share in global trade. Such a phenomenon draws attention to the inherent volatility that exists within these carry trades, especially as the BoJ begins to unwind its ultra-accommodative stance. As the cost of yen borrowing rises in contrast to other currencies' interest rates, the potential profitability from these trades diminishes—a scenario likely to instigate significant adjustments in global financial markets.

Historically, Japan’s tightening cycle has induced global market tremors. Consider the instances from 2006 to 2007 when Japan's rate hikes triggered a rush to close carry trade positions, leading to severe liquidity constraints that exacerbated the subprime mortgage crisis in the U.S. This played out dramatically, with equity indices worldwide suffering steep losses and market instability sparking a broader financial crisis.

As we look towards the horizon, it is clear that Japan stands at the threshold of a new era in its monetary policy. With inflation returning after decades in the dark and a cautious optimism emerging in economic conversations, the road to normalization is fraught with complexities rooted in both the local economy and the interconnectedness of global financial systems. We may witness further rate increases in the coming years, expected to stabilize around multiple increments bringing rates up to 0.75% by 2025. Nevertheless, investors would be prudent to prepare themselves for the inevitable market volatility that accompanies these changes.