Is Abenomics Working?
Japan has embraced stimulative economic policies and ground-breaking initiatives in terms of accommodative monetary policy in an attempt to reverse 15 years of uninspiring economic growth and chronic deflation. This special commentary considers the extent to which Abenomics is helping to stimulate the economy and whether the monetary policy measures known as Quantitative and Qualitative Easing (QQE) by the Bank of Japan (BoJ) are having the desired effect of creating inflation by doubling the monetary base. (Figure 1 and Figure 2).
The first two arrows of Abenomics (large-scale fiscal stimulus and aggressive monetary easing from the Bank of Japan) were generally well-received. The third and final arrow (structural reforms to boost Japan's competitiveness) has thus far been uninspiring. The modest reforms and creation of new deregulated economic zones fell short of high expectations for more sweeping labor reforms and new ways of dealing with agricultural regulation, free trade and immigration policy. Two out of three will do for now. We think that the fiscal stimulus and monetary policy easing alone will exert a positive boost on the Japanese economy. However, as we said in April, to make lasting improvement in the rate of economic growth, Japan must increase potential GDP by embracing free trade, and it must reverse the declining labor force either by promoting higher female labor force participation or by taking a more open-door approach to immigration. Potential reforms are outside the scope of this report but will be addressed in a future publication.
It is tempting to point to soft second quarter growth figures as proof that Abenomics is not sufficiently boosting GDP or to suggest the recent pick up in inflation is evidence that QQE is having its desired effects. However in this report, we lay out our case for why that sort of kneejerk analysis can be dangerous. Abenomics is underpinning domestic demand, but inflation is not yet a direct result of QQE.
Miss in Second Quarter GDP Should Not Be Pinned on Abenomics
Second quarter GDP figures out of Japan were a disappointment for financial markets that had come to view Abenomics as the panacea for all that ailed Japan. Consensus expectations for the second quarter were for an annualized growth rate of 3.6 percent. The actual outturn of 2.6 percent growth was off by a full percentage point and most analysis focused on the shortcomings and disappointing aspects of the report (Figure 3). We think it is useful at this point to consider among the stated goals of Prime Minister Abe's plan were to stimulate private investment for stronger growth and to boost exports. That largely seems to have worked, at least in the second quarter. While a faster growth rate might have offered a more full-throated endorsement of recent policy initiatives, it was an inventory drag that was primarily to blame for the miss.
Japanese consumer spending grew at an annualized rate 3.1 percent in the quarter. This was not terribly surprising given the upturn in retail sales during the quarter. Business investment spending increased at a 1.4 percent clip. Strong demand in the domestic economy resulted in import growth of 6.2 percent in the second quarter. While the pace of import growth was the fastest it has been in Japan in at least a year, exports grew more than twice as fast as imports at a 12.5 percent annualized rate. Final domestic demand rose to a 2.8 percent annualized rate in the second quarter, the fastest clip in more than a year. Inventory reduction exerted a full percentage point drag on the top-line growth figure.
So a weaker-than-expected GDP print for the second quarter does not raise doubts about the early effects of Abenomics in our view. Indeed, over the past several years the preliminary estimate of GDP growth has had a tendency to undershoot subsequent revisions to the growth rate. The next revision due out September 9 will take into account a broader measure of government spending, which may capture more of the fiscal policy spending initiatives.
How Much of the Recent Uptick in Inflation Is Due to QQE?
In our earlier discussion we suggested that Abenomics was not to blame for the miss in second quarter GDP figures; in this section we make the case that the recent upturn in inflation should not be credited to Abenomics, at least not entirely.
After 15 years in which deflation was the over-arching price dynamic, the Bank of Japan (BoJ) rolled out a sweeping new set of monetary policy tools to more than double the monetary base in the span of two years with the stated goal of lifting the CPI inflation rate to 2.0 percent. The central bank has branded this operation Quantitative and Qualitative Monetary Policy Easing or QQE, for short. While we think the goal is laudable, we suspect in the final measure it may be difficult for the BoJ to pull off. Our forecast has consistently been below the consensus for full year CPI in 2014. The consensus expectation at this point is spot on the target rate of 2.0 percent, we are somewhat more reserved with our expectation of 1.5 percent.
In its most recent meeting minutes, the BoJ noted that the year-over-year rate of CPI inflation turned positive and that inflation expectations appear to be on the rise. As to the expectations component, that is frustratingly hard to quantify.1 The BoJ has its own survey that asks households about inflation expectations, and indeed that has picked up modestly. The most recent survey conducted between May and June tells us that 62.9 percent of Japanese households expect prices to go up slightly over the next year. While that figure is down slightly from the 63.8 percent who expected a slight increase back in March, the share of households expecting prices to go up significantly increased from 10.4 percent in March to 17.3 percent in the May to June period.
Ordinarily we would prefer a market based measure to an opinion survey. In the United States for example, a TIPS spread (the difference in yield between a Treasury and an inflation-protected Treasury of the same maturity) would be a superior measure to a survey answer. Japan has similar instruments, inflation-protected Japanese Government Bonds (JGBi). The problem here of course is that in a land where deflation has ruled for 15 years, there is not much appetite for inflation protection. Consequently, JGBis are thinly traded and the Ministry of Finance has historically been the biggest buyer. Other attempts have been made to infer price expectations using yen/dollar forward exchange rates or a differential of purchasing power parity against another economy. In the absence of a reliable proxy, the best approach may be to keep tabs on the surveys and the forward rates.
The BoJ pointed to the increase in headline inflation in its most recent meeting announcement and many market watchers have cited the advance in consumer prices as an early indication of the success of QQE (Figure 5). While we think that the unprecedented monetary policy initiatives will succeed in driving prices higher, the recent uptick in the CPI is not yet evidence of the plan's success.
To be sure, some of the increase in prices is a function of yen weakness which is most certainly a result of BoJ policy, a point that we willingly concede. As Figure 6 illustrates, the yen weakened more than 10 percent in the weeks that followed the April BoJ meeting when QQE was formally announced before retracing some of those losses more recently.
Some categories of prices are more susceptible to currency depreciation than others. Outlays for domestic services for example will be rather resilient to yen weakness. Domestic food prices would not immediately be affected either, though over time, increased feed costs could eventually translate into higher food prices. Culture and recreation prices and housing costs should remain somewhat insulated from a weak-yen policy as well.
Fukushima's Lasting Impact on Prices
The key driver for higher inflation not just over the past few months, but indeed over the past year has been the higher cost for energy, specifically fuel, light and water. However this is not only a function of a weak yen. Figure 7 looks at the year-over-year rate of CPI inflation in Japan. The line is the headline CPI figure. Each of the stacked bars shows the contribution of the various components to the overall figure for each month. What becomes clear in looking at this graph is that the category fuel, light and water has been boosting the overall inflation reading for each of the past 12 months. The magnitude of that contribution has increased since the introduction of QQE, but energy prices were already exerting a clear inflationary influence.
So the story here is more than simply the fact that a weak yen is causing energy prices to rise. What also seems to be at play is the high and rising cost of imported liquid natural gas into Japan. In the wake of the tragic Fukushima disaster in March 2011, not only are the affected nuclear reactors no longer functioning, but a number of other reactors were taken offline as well. Just over one year after the disaster in May 2012, the last of Japan's nuclear generators went off line for maintenance leaving the island nation without nuclear power for the first time in more than 40 years. A few reactors are back up and running, but domestic sentiment has certainly become very hostile toward nuclear-generated power.2 The result of this in terms of inflation is that Japan is importing a lot more liquid natural gas and paying a lot more for it. In most parts of the world, natural gas prices are much lower today than they were at cycle peaks in 2005 and 2008, but in Japan imported natural gas prices are at an all-time high (Figure 8).
Having said that, it is not as though QQE is not having any effect on prices. The rate of deflation for categories other than fuel, water and light has been slowing since the announcement of the new program in April. If this trend continues (and we suspect it will) then slower deflation will soon give way to outright price increases and the elusive goal of inflation.
Debt and Taxes
Against this backdrop of an incipient economic recovery and a whiff of inflation, there has been a great deal of hand-wringing over the impact of the looming tax increase scheduled for April 2014. According to terms of a bill passed last year, the consumption tax in Japan is set to increase to 8.0 percent in April from the present 5.0 percent before climbing to 10.0 percent in October 2015. The Abe administration has been torn about how to approach the issue with one top aid to the prime minister recently remarking that the government should not "step on the gas and put on the brakes at the same time."
But Abe's hand-picked governor at the Bank of Japan disagrees. Governor Kuroda has downplayed the negative impact on the economy and has publicly called on the government to pass the tax hike saying "I don't think the sales tax hike will lead to a slump in the economy or hamper the achievement of the (BoJ's) 2.0 percent inflation target."
Outside parties like the International Monetary Fund have weighed in as well, generally taking the stance that raising the consumption tax is a necessary evil to combat the country's fiscal vulnerabilities. We tend to align our thinking with this sort of analysis. There is nothing wrong with tightening fiscal policy while simultaneously embracing a more accommodative monetary policy stance. Indeed, it was a similar combination that allowed Canada to address its fiscal issues in the mid-1990s.3 The most obvious difference is that Canada had significant room to cut its overnight lending rate. With rates already at near zero, it would be more difficult for Japan to ease monetary policy further, but there is no reason in our view why tighter fiscal policy and more accommodative monetary policy cannot be pursued at the same time.
Our view at this point is that the tax hike will go through as planned. The government needs to raise revenue and any attempt to renegotiate terms at this point would require new legislation. If he were to disrupt its implementation, Prime Minister Abe would associate himself directly with a tremendously unpopular piece of domestic legislation. He can offer lip service against it, but we suspect the existing legislation will hold and the tax hike will go through.
Governor Kuroda suggested that the tax increase will not lead to a "slump in the economy." It may not push the Japanese economy back into recession, but we do expect second quarter GDP growth to be negative in the second quarter of next year. Still, some of that will simply be a function of the fact that many large purchases will likely be pulled forward into the first quarter as consumers try to get a big buy in before the higher tax rate goes into effect.
In economics, things are often not what they seem. We know that QQE is designed to create inflation and just a few months after its implementation, voila! We have inflation. However a closer analysis of the details of the CPI report tells us that the real driver of higher prices is increased energy costs.
In a similar way, we know that Abenomics is supposed to boost GDP growth, but growth slowed in the second quarter so it is tempting to think the medicine is not working. However when we exclude the impact of inventories and trade, we find the fastest pace of growth in total domestic demand in over a year.
This does not mean we think Abenomics is a perfect fix. We think it will lift full-year GDP growth to 1.8 percent this year and 2.3 percent in 2014. Beyond that, continued gains will require bigger structural change than is currently being offering by the third arrow of Abenomics.
Our inflation forecast looks for inflation of just 0.3 percent this year and 1.5 percent in 2014. We are below consensus with the inflation forecast; sustained indications of price growth outside the energy sector would signal upside risk to our present forecast, but at this point we see only a slower pace of deflation. While that is a good start, it may take longer to get to 2 percent than many market-watchers presently expect.