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Can Japan break the deflation cycle?
With deflation the major drag on growth and the biggest long-run economic threat, pressure was growing on the Bank of Japan to respond. And it did Ė with yet another round of quantitative easing and by announcing an inflation target of 1%. But then, are these measures enough to bring the Japanese economy back on track?
Issue Date - 15/03/2012
At a time when major economies across the globe are finding it hard to rein in galloping inflation, the Bank of Japan (BoJ) has stunned the world by announcing its intention to hit a newly established (for the first time ever) near-term inflation target of 1%. Economic growth, currency devaluation, or drag on productivity: whatís the motive?

The reason is simple. To break the deflation cycle and a strong yen, both of which have been choking off Japanís economic growth over the past 15 years. In fact, the two problems are interconnected. Typically when central banks pump liquidity into markets following recessions, businesses and consumers borrow, growth picks up and eventually inflation rises. This is not the case in Japan, where deeply entrenched deflationary expectations and other factors weigh on loan demand. The combination of deflation in Japan and inflation elsewhere pushes up the purchasing power of the yen relative to other currencies. A strong yen in turn weighs on exports, the main driver of growth in the Japanese economy. And thatís exactly what is happening in the ďLand of the Rising SunĒ. Japanís economy shrank for the third time (between October & December 2011) in the last four quarters. The first estimate of Japanís fourth quarter GDP showed the economy contracted 0.6%, significantly worse than consensus forecast of a 0.3% decline. This is equivalent to a 2.3% fall in GDP on an annualised basis. Further, while Japanís monthly trade deficit widened to •613 billion in January, following Decemberís •569 billion shortfall, yen sits high at •80.30 against the dollar.

Sadly, deflation also adds to the real burden of public debt, which is a major problem for Japan. With a public debt figure to GDP ratio hovering around the 200% mark (The Bank of International Settlement projects that even under ďa best case scenarioĒ Japanís debt could zoom past 400% by 2040!), its situation is worse than even the most recent citadel that fell Ė Greece. Interestingly, all the while the countryís GDP hasnít moved an inch. Japanís nominal GDP is almost the same as it was about 15 years ago ($5.58 trillion today as compared to $5.24 trillion in 1995). Unbearable debt amidst close to zero growth in over 15 years puts Japan in an awkward macroeconomic situation!

Thus, to get out of this status quo Japan is once again relying on a technique called quantitative easing (QE). As opposed to flooding the money supply with newly printed currency, the BoJ has announced to pump 10 trillion yen ($130 billion) into the economy through purchases of government bonds by the end of 2012. But while the QE will lift the supply of money, policymakers face a greater challenge in trying to get households and businesses to borrow. So, will the BoJís latest move succeed in breaking the deflation cycle?

Previous bouts of quantitative easing and currency intervention did not have a sustained downward impact on the yen, lift inflation, or provide a meaningful boost to the real economy. Agrees Matthew Circosta, the Sydney based Economist at Moodyís Analytics as he tells B&E, ďThese policies have been rendered useless because of the deflation mind-set embedded in Japanese consumers and businesses.Ē Excluding the oil-induced inflation spike before the 2008 crisis, core inflation hasnít reached 1% since 1997.

Although investors believe that the BoJís actions will deliver inflation in the medium to long term as seven-year breakeven inflation rates have been trending upward, turning positive in February for the first time since the 2008 crisis, it wonít really help start the economic growth engines as Japanís deflation problem is driven by a lack of demand, which has already created a sizable output gap. Japanese consumers are frugal and businesses are typically cautious.

No doubt, due to government intervention, yen, the Japanese currency, has shed some value in recent weeks to sit at a seven-month low of •80.44 (as on February 28, 2012) against the dollar, more than 5.5% off its record high in October 2011 (since 2006, the yen has risen more than 34% against the dollar and 33% against the euro), but it is still causing grief as Japanese exporters are becoming less and less competitive against cheaper rivals. Moreover, the bigger question is: Can the yenís downward trend continue? Sustained powerful QE from the BoJ could help. Ultimately, however, the answer is no because Europeís crisis presents severe downside risk to the global economy, which tends to support the yen. So whatís the way out?

Japanese policymakers now really need work alongside domestic companies to boost demand by unleashing the latent spending power of the elderly, who sit on the vast majority of Japanese householdsí savings Ė a whopping $18 trillion. Itís really important at a time when a large chunk of baby boomers are set to retire increasing Japanís elderly population manifold. As per the National Institute of Population and Social Security Research of Japan estimates, while the percentage of aged population (65 years and older) is set to increase to 35.7% by 2050 from 19.5% in 2004, the productive age population is forecasted to go down to 53.6% by 2050 from over 66% in 2004.

On the policy front, the BoJ can learn from its global peers. The Japanese central bank needs to set a deadline in achieving its inflation goal, in the same way the US Fed has expressed it will keep interest rates low until 2014. If the goal is not met, the bank will then need to explain why it missed, as is the case for the Bank of England and Reserve Bank of New Zealand. These binding commitments could help motivate the BoJ to throw everything at the problem until it hits its target.

Last but not the least, the Japanese central bank should lift its inflation goal to 3% to 4% (even suggested by IMF in 2010), in line with the worldís other central banks. After all, itís much easier to be a central banker in an environment of inflation rather than one mired in deflation.

Manish K. Pandey           

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