Japan’s deflated record on monetary policy

Senior Fellow, RIETI

Japan has used monetary policy to stoke inflation since Shinzo Abe became prime minister in 2012. But as inflation exceeds 8 per cent in the United States and Europe and 10 per cent in the United Kingdom, Japanese inflation averaged less than 2 per cent between January and July 2022. The question is why the Bank of Japan (BOJ) has failed to hit its inflation target despite purchasing 400 trillion yen (US$2.8 trillion) worth of government bonds over the last ten years.

Japan has a long history of monozukuri, or manufacturing. During the post-war period, firms such as Toyota, Panasonic and Sony became world-class manufacturers. Competing in world markets forced them to innovate to satisfy consumer demand. Profits and wages increased as they succeeded — and out emerged the Japanese economic miracle.

Many shocks then buffeted the Japanese economy. The global financial crisis was particularly devastating. Japanese industrial production fell by 35 per cent, real exports fell by 40 per cent and the Nikkei 225 stock price index fell by 80 per cent during the first two years of the crisis. The Japanese real exchange rate appreciated by 30 per cent. That played a key role in causing exports to fall and Japanese firms to lose price competitiveness, especially in the automobile and electronics industries.

To maintain competitiveness, many Japanese exporters kept export prices constant in foreign currencies. The strengthening of the yen caused the export prices denominated in yen to fall without decreasing the costs of production in Japan. Export prices fell on average by 30 per cent more than yen-denominated costs — crushing firms’ profit margins. Japanese firms responded by transferring production abroad and making high-end goods in Japan.

Deflation gripped the country from February 2009 until 2013, reaching a trough of -2.6 per cent. During the 2012 election campaign, Abe argued that the BOJ should print unlimited quantities of yen to fight deflation. BOJ Governor Haruhiko Kuroda implemented this expansionary monetary policy after Abe won the election. The yen depreciated by 55 per cent between November 2012 and the end of August 2022. Yet this policy has still failed to generate inflation driven by consumer demand.

In the past, a weaker yen increased the price competitiveness of Japanese firms and raised exports. But after Japanese firms offshored production during the global financial crisis, the weaker yen has done little to increase exports. That mutes the impact of the depreciation on the employment and wages of Japanese workers in export industries.

The high-end goods that Japanese firms now export, such as ceramic capacitors and image sensors, require advanced technologies and skilled workers. When the weaker yen increases exports, it benefits high-skilled workers who already receive higher salaries. Normal manufacturing workers in export industries, who prospered during Japan’s post-war boom, do not share in these gains.

Large corporations such as Toyota find that the weaker yen increases the yen value of repatriated profits from overseas production and sales, increasing their stock price. Wage gains for high-skilled workers and higher stock prices primarily benefit those at the upper end of the income distribution. The weak yen does little to raise aggregate consumption because the marginal propensity to consume of rich workers is lower than the marginal propensity to consume of poor workers.

That makes life hard for Kuroda, who has pledged to maintain expansionary policies until increases in wages and consumption drive inflation. The BOJ has maintained low interest rates while the Federal Reserve, the European Central Bank, the Bank of England and many other central banks are raising rates.

His task is made harder by the reluctance of Japanese firms to raise prices in the Japanese market. Companies have a strong sense of loyalty to their customers and are concerned they will lose business if they raise prices. Even though it hurts their profit margins, firms often choose to absorb increases in input prices rather than raising the price of final goods.

If the yen keeps weakening, it risks creating a vicious cycle. A yen that weakens relative to the US dollar increases the costs of imported energy and commodities denominated in US dollars, increasing the Japanese trade deficit. Japan ran trade deficits every month between August 2021 and July 2022. The yen might further depreciate as the trade deficit feeds into the current account deficit. Japanese policymakers should be ready to act if the depreciation becomes disorderly. The BOJ did intervene on 22 September by purchasing yen. But intervening in foreign exchange markets without changing interest rate differentials between Japan and other advanced countries is unlikely to strengthen the yen very much over time.

Abe proposed three types of policies — monetary policy, fiscal expansion and structural reform — to revitalise the Japanese economy. He poetically labelled these the three arrows. In practice, policymakers have relied on the arrow of monetary policy. While expansionary monetary policy has caused the yen to depreciate, the weaker yen has not succeeded in raising wages or consumption. After Japan moved much of its manufacturing offshore, the weaker yen no longer stimulates exports nor does it have the impact it once did on the employment and wages of manufacturing workers.

Stagnant wages and limp consumption are serious problems for Japanese residents. They also prevent inflation from reaching the BOJ’s target. But these problems cannot be solved by expansionary monetary policy alone.

October 1, 2022 East Asia Forum

November 1, 2022

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