Japan deflation threats revive

by: Maritza Cabezas

012115-Japan-Watch3.pdf ()
  • As a net energy importer, Japan will benefit from the lower oil prices, but it may generate concerns about a delay in reaching the 2% inflation target. In today’s Monetary Policy Meeting, the Bank of Japan lowered the core CPI outlook for FY 2014 to 0.9% from 1.2% and for FY 2015 from 1.7% to 1%, mainly on account of lower oil prices. We have adjusted our core inflation 2015 forecast to 1% from 1.7%.
  • We have also sharply lowered our FY 2014 GDP growth forecast to -0.4%, from 0.3%, and maintain our FY 2015 GDP growth forecast at 1.4%. Despite the positive impact on disposable income of lower oil prices, we think that consumers will only gradually increase their spending as wage growth begins to pick up.
  • We think that the substantial downside revision of the Bank of Japan’s inflation forecast suggests further monetary easing will be necessary, while structural reforms will support the economy’s long-term economic performance.
  • We expect the yen to decline to 130 by the end of this year and 140 in 2016.

Japan never ceases to surprise

After Japan announced that GDP growth in the third quarter of 2014 had declined by an annualised 1.6%, Mr Abe called for snap mid-term elections and stated his intention to postpone the consumption tax hike. Investors were surprised, but reacted positively.  The political calculus was that a renewed mandate would give Mr Abe enough time to pursue structural reforms, notably the much-awaited “third arrow” of Abenomics. We think that this could result in only short-optimism unless Mr Abe manages to deliver concrete measures. He also needs to show clear signs that he has concrete fiscal consolidation plans.

Monetary expansion starting to deliver…

We think the economy will gradually recover in the coming months. The monetary expansion announced at the end of October 2014, from 30 trillion yen to 80 trillion yen annually, is the largest among the major central banks. Since the announcement, Japanese equities have posted strong gains. Moreover, long-term interest rates have fallen to historical low levels, hovering around 0.2%. But the most important achievement has been the depreciation of the yen. The yen’s decline is even more dramatic when viewed in terms of the real effective exchange rate, which captures international price competitiveness against its main trading partners.


 …while lower oil prices are favourable for trade

On top of a weaker currency, Japan, like other net importers of oil, will benefit from lower oil prices. Lower crude oil prices will improve trade income and strengthen corporate profits, particularly of energy-intensive industries, including firms in the transport sector and producers of chemical basic products. Our estimates suggest that in Japan, a USD 50/barrel drop in oil prices would provide windfall gains of around 1.5% of GDP.

The sharp decline in oil prices has strengthened the terms of trade significantly. This is mainly the result of Japan’s reliance on external sources of energy. In November, the improvement led to the smallest deficit since May. Ahead, we think the terms of trade gains are likely to persist as import prices continue to fall, lagging behind the decline in oil prices. This shift would turn the trade balance into a surplus.

termso of trade

Households will benefit from higher disposable income, which is welcome given the impact of the tax hike on Japanese households. This rise in disposable income should partly result in a modest increase in consumption growth. Consumer confidence already picked up somewhat in December for the first time in four months on the back of lower gasoline prices and the postponement of the consumption tax hike.

 … but inflation to fall further

At the same time, a sudden drop in oil prices will contribute to putting downward pressure on prices and may generate concerns about a delay in reaching the 2% inflation target. In January’s Monetary Policy meeting, the BoJ lowered the core CPI outlook for FY 2014 to 0.9% from 1.2% and for FY 2015 from 1.7% to 1%, mainly on account of lower oil prices. The past relationship between oil prices and inflation suggests that a 10% drop in oil prices will reduce core CPI, which the BoJ uses as its price target, by about 0.1pp. We think that the BoJ’s substantial downward revision to the core CPI outlook suggests it is much less likely to meet its target for 2% inflation around FY2015.


BoJ options for keeping economy on track

As inflation slides away from the 2% target, there are still several options that the BoJ could contemplate. The easiest would be to revise the two-year period for reaching the inflation target of 2%, but this could damage the central bank’s credibility. Other potential measures include a negative interest rate applied to the BoJ’s lending to banks and more equity-linked ETF purchases, or an IOER. Launching an asset-backed security purchase programme is also a possibility. We think that the BoJ will opt for additional monetary easing in July 2015 as it becomes clearer that inflation is not heading towards its target.

 Fiscal reform still in the planning

The FY15 tax reform outline, which was approved by the cabinet at the end of 2014, incorporates a corporate tax cut of roughly 2.5% from the current level. We think that corporate activity is essential in pushing aggregate demand through wage growth. The tax reform firmly reflects Prime Minister Abe’s policies under ‘Abenomics’, which aim to promote economic recovery through aggregate wage expansion as a result of stimulating corporate activity. This year’s budget is able to increase tax revenues by about 9%, but social welfare expenditure will take up a large part of these revenues, accounting for about one third of the total budget. Our forecast for the Japanese budget deficit this year is -6.5% of GDP.


The outlook

Although Japan still has a long way to go to achieve a steady recovery, there is no doubt that deflation is the major risk. Therefore, we expect additional monetary easing in July 2015. Moreover, the growth strategy, or “third arrow,” of Abenomics is still to hit some of the right targets. It could fail to lift potential economic growth unless Mr Abe prioritises and spends his political capital carefully. To be fair, Abenomics is making some progress on growth strategy, for instance, with corporate tax reforms and the depreciation of the currency, but firms will need to increase wage growth for consumption to lift off.  We expect the yen to decline to 130 by the end of this year and 140 in 2016. We expect the surprise element of the BoJ moving will exert further downward pressure on the yen.