The government and the Bank of Japan (BOJ) are joining hands in a bid to pull Japan out of its prolonged deflation. In January 2013, the central bank set a 2% inflation target, and in April, it declared it would take an unprecedentedly drastic credit-easing policy, including attaining 2% inflation within two years. With the announcement of the new monetary policy, people began to change their forecasts of the price trend. Meanwhile, moves to raise shipment prices for such products as wheat and mayonnaise began to emerge among businesses. The consumer price index (CPI) increased 0.4% in June from a year earlier following months of year-to-year decline.
But the recent price uptrend was mainly attributed to hikes in power and gasoline prices. The persistent view is that prices for most other products have yet to show signs of rising. In fact, the daily price index compiled by a University of Tokyo project team for commodities sold at supermarkets decreased 0.9% as of July 26, 2013 from that of a year before. The margin of decline under the survey has been gradually shrinking, but the tempo of the fall has been slow, indicating that manufacturers' moves to raise shipment prices have yet to be felt fully by the end consumers. In view of the latest price trend, some critics say that it is difficult for the BOJ to achieve the 2% inflation target within the set period.
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During the Great Depression in the 1930s, the United States was gripped with deflation. The phenomenon has been studied by many economic experts including U.S. Federal Reserve Board Chairman Ben Bernanke. Studies have found that the United States was able to overcome deflation following policy changes by the Franklin Roosevelt administration. In a departure from the gold standard system, a belt-tightening fiscal policy and a "small-government" policy, President Roosevelt adopted an expansionary fiscal policy while tolerating devaluation of the U.S. dollar. As a result, people stopped forecasting deflation and began anticipating inflation.
An important point about Roosevelt's actions was that he did not respond to individual monetary and fiscal problems but rather changed the rules of the game for formulating policies, and transformed the policy regime. The surprising point was that Roosevelt changed the policy regime overnight, not over time. This is similar to what the government of Prime Minister Shinzo Abe is trying to do—to implement a policy changeover in a packaged manner to achieve quick results.
Deflation in Japan differs from the one that hit the United States during the Great Depression in two ways, and they explain why combatting deflation is difficult in the former. The first difference is the pace of deflation. Japan's CPI moves within a narrow range, with its margin of decline hitting a maximum of 2% and averaging less than 1%. By contrast, the pace of deflation in the depression era United States was much faster, with its CPI falling by an annual average of 8% between 1931 and 1933. The second difference is the length of deflation. In Japan, deflation has continued over many years, lasting more than 15 years since the mid-1990s. Consequently, the Japanese people's mindset regarding the economy has always come with expectations of deflation. But the deflation during the depression era in the United States ran its course only within two years and was quickly followed by inflation.
These differences derive from different corporate attitudes between Japan and the United States regarding price setting. During the Great Depression, U.S. companies changed the prices of their products and services speedily in accordance with the supply-demand balance. But in recent years, Japanese companies have become more reluctant about changing prices in response to changes in supply-demand relations.
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Increased price rigidity in Japan is reflected in the historical changes in the Phillips curve, which is an inverse relationship between the rate of unemployment, shown on the horizontal axis, and the rate of inflation, shown on the vertical axis. As clearly shown in the graph, in the 1980s, prices increased when unemployment decreased. But in the 1990s, the curve became less steep. This trend became more conspicuous in the 2000s, with the curve becoming flatter. In other words, the rate of unemployment has fluctuated in accordance with changes in demand but has been little affected by price rises.
What does the flattening of the Phillips curve mean to efforts to overcome deflation? The rate of unemployment falling as a result of higher demand while prices do not rise is a good thing when the economy is going through an inflationary phase. But if the same phenomenon occurs in a deflationary phase, a situation Japan is currently experiencing, pulling out of deflation is difficult. If that occurs, people predict that price declines will continue in the future, putting further downward pressure on economic growth.
How much does the supply-demand gap need to be narrowed in order to raise prices by 2%, if the bend in the Phillips curve remains unchanged? According to our calculation, fresh demand totaling 50 trillion yen needs to be created. If demand is to be boosted by that amount within two years, Japan's real gross domestic product (GDP) needs to grow by an annual rate of 6.3%. Even if the deadline is extended by one year, the minimum GDP growth necessary will be still high at 4.5% per year.
Attaining the figure is generally assumed to be impossible. The calculation of the minimum GDP growth is based on the assumption that the line that bends under the Phillips curve will remain unchanged in the future. What we should learn from the calculation is that the assumption should be changed in order to achieve the 2% inflation. In other words, the bend in the Phillips curve should be made steeper if Japan is to pull out of deflation.
The question is whether or not the Phillips curve has changed since the Abe government's inauguration in December 2012. The graph shows the month-to-month relationship between the rate of inflation and the rate of unemployment during the period January 2012 to June 2013. As the graph indicates, little has been changed in the Phillips curve during the period.
Competing with rival companies is seen as a major reason for the flattening of the Phillips curve. Manufacturers and distributors are not bold enough to raise the prices of their products and services simply in response to higher demand or cost out of the fear of spurring customers to switch to their rivals. This behavior leads to an economic phenomenon known as "coordination failure," in which demand or cost change on a macro-economic level does not affect prices. Since the Abe government first took office, companies have become more positive about changing prices. But the changes have not been as significant as making the Phillips curve steeper.
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To attain the 2% inflation target, the government and the BOJ should first change companies' attitudes toward price setting. Companies refrain from raising prices despite higher demand because they cannot drop their forecast of continued price decreases in light of their past downtrend. If companies are convinced that prices will turn up from now, however, they can expect their rivals to adopt a policy of raising prices.
For that to happen, the government and the central bank should send a stronger message to the markets and others that the Japanese economy is set to enter a phase of higher prices. The Diet has recently enacted legislation aimed at adequately transferring the planned consumption tax hike into product prices. The law is designed for companies to reflect higher costs from the tax hike in their product prices. Business conditions for companies should be further improved so that they can adequately transfer to their product prices the cost and demand changes derived not only from the consumption tax hike but also from other factors.
Second, the BOJ should continue monitoring whether or not the 2% inflation target is steadily being achieved, and it should also disclose its progress. Recent studies on the quantitative monetary easing that has been implemented in the United States and the United Kingdom show that the policy has been effective in pushing up the prices of assets such as stocks but not in lifting other prices. It remains to be seen if drastic credit easing under the Abe government will be effective in lifting prices in Japan. Closely monitoring possible developments is therefore indispensable in Japan.
If achieving the 2% inflation target is found to be difficult, the BOJ should immediately state the assessment to the market under the "forward guidance" policy-prospect announcement system and come up with additional measures including expanding the purchase of assets. Doing so is necessary from the viewpoint of seeking to achieve quick results to make the credit policy successful.
* Translated by RIETI.
July 31, 2013 Nihon Keizai Shimbun
