In memory of Dr. Andreas Höfert

Unintended consequences of Abe's monetary arrow

| Tags: Andreas Höfert

When Shinzō Abe started his second term as Japan's prime minister in December 2012, he introduced an ambitious economic program to pull Japan out from two decades of deflationary slump. This program comprised three so-called "arrows": fiscal stimulus, monetary easing and structural reforms. Meanwhile the first two arrows have been shot but the third is still in the quiver; once again it has been easier for a government to print and spend money than to reform.

Nevertheless Japan does look healthier now than a year ago. GDP growth in 1Q 2014 reached 6.5% annualized, and more importantly, Japan seems to have escaped its 20-year incarceration in deflation. Excluding a three percentage point VAT hike on 1 April 2014, Japan's core consumer price index was up 1.3% in June compared with last year. Hitting the 2% inflation target, the aim of the second monetary arrow of doubling the monetary base within two years, appears assured.

But why is leaving a deflationary environment such a good thing? Is inflation really beneficial for growth?

The first question is easily answered by looking at the Japanese public debt: it is off the charts. According to the International Monetary Fund, Japan's gross public debt-to-GDP ratio stood at 243% in 2013. Quick calculation shows how destructive deflation has been. If instead of a GDP deflator averaging -0.5% per year between 1990 and 2013, Japan would have had 2% inflation on average, the public debt-to-GDP ratio would stand at 133%. Deflation alone accounts for more than 100 percentage points of the current ratio. So it is no wonder that the Japanese government longs for inflation.

The second question is trickier. Usually excessive growth causes inflation rather than inflation leading to growth. However, one can consider two channels through which inflation might boost growth: international trade and private consumption.

Inflation or expectation thereof will usually weigh on the external value of a currency, fostering decline of export prices and boosting international competitiveness. Indeed, since the beginning of 2013, thanks to the ultra-lose monetary policy of Abenomics, the Japanese yen has lost roughly 20% of its value not only against the US dollar and the euro but also against Asian currencies like the Korean won or the Chinese yuan. This can explain why Japanese exports grew in 1Q 2014 in real terms at a rather solid 9% compared with the year before.

However, the Japanese trade balance picture is less rosy. In May (most recent figure) the Japanese trade deficit stood at over one trillion yen, deeper than in December 2012. This is an unintended consequence of yen weakness: imports have become more expensive, while demand for some of those imports is not really decreasing because of higher prices. Since December 2012, oil prices expressed in Japanese yen have increased by 33%, and since the Fukushima catastrophe, Japan is more dependent on oil than ever.

Deflation can depress private consumption. Purchases might be delayed because prices are expected to decline. The return to inflation might therefore boost Japanese consumption. Private consumption did post a rather solid 3.5% growth rate in 1Q 2014 compared with the prior year. But since then, consumption indicators like retail sales have stalled at best.

Another unintended consequence is at play: inflation will only boost consumption if income also rises. However, Japan is currently undergoing a stagnation of nominal personal income coupled with an inflation rate (including the VAT hike) of over 3%, which has severely reduced real personal income.

Japanese wages therefore need a boost. But this could make Japan less competitive again. Further, the latest Tankan business survey reports the private sector to be less confident about Japan's economic prospects, which bodes poorly for pay rises. Maybe it's time to fire that third arrow of Abenomics.