Possible reasons why the inflation and wage growth in Japan have stubbornly refused to rise:
- institutional factors in CPI,
- using published unemployment in the Phillips curve,
- a decline in potential growth,
- structural changes in the labour market,
- the long run stable relationship between wages and labour productivity.
Three of them are to do with prices and the last two with wages.
These are my notes based on a DB report.
Institutional factors in CPI:
Health care and education costs are largely decided by government policy, hence demand/supply effects are limited in Japan.
Enrolment in health insurance is compulsory for everyone in Japan. It is also government policy to lower drug, medical diagnostic and treatment costs. As a result, the share of medical spending in the CPI is much lower compared to France or the US.
Education up to secondary level is free while tuition for higher education is regulated by the government. Note: As a share of CPI, Japan has the highest education spending compared to other developed countries. This is attributed to spending on supplementary education (e.g. tuition classes, private school, prep school). However, the growth of the education cost is the slowest among the developed countries.
Imputed rents are more influenced by old houses, of which quality improvements/ renovations have been limited. Imputed rents in owner-occupied housing are not included in the CPI weighting in the main European countries. Japan has a tendency in which owner-occupied houses exhibit a deteriorating quality relative to rental houses because the former consists of a larger share of older wooden homes with limited maintenance being done and the latter consists of relatively new condos and homes with better maintenance. The price of the latter (actual rents) is less likely to decline than imputed rents. We also believe that quality adjustment to prices in this case has not been properly reflected. In other words, we need to raise imputed rents in order to reflect the quality deterioration, but this is not done. It is an opposite bias to the prices of IT goods. (In IT goods, an improvement in quality has to be reflected as a fall in prices in the CPI.)
Using published unemployment in the Phillips curve:
The Phillips curve shows the short-term relationship in the business cycle that exists between inflation on the vertical axis (not the rate of rises in wages but prices) and indicators showing the utilisation of factor inputs on the horizontal axis (e.g. the unemployment rate).
The Phillips curve is just another analytical tool to help with policy making. Like any other tools, analysis using the Phillips curve has its limitations.
Short-run constraints:
- It is common to use unemployment rates as indicators of labour market slack but if there is a long term structural change, this will also be reflected in the unemployment rate.
- When work sharing is carried out (e.g. with Japan’s part-time workers) because of the negative incentives to labour supply in the tax system, using published unemployment (e.g. headcount) may overestimate the tightness in the labour market. A polarization of labour markets between part-time and full-time workers in Japan and the fact that the interaction between the two has been limited is thought to be a Japan-specific factor contributing to the lack of emerging upward pressure on wages despite an improving economy. The order in which companies respond to an economic recovery is to increase part-time workers, to raise part-time workers’ wages, to increase the hire of new graduates and raise their starting salary, and to increase overtime pay and bonuses for full-time workers, with a very high hurdle to raising existing full-time workers’ monthly salary.
- Operating rates of capital are not reflected on the horizontal axis. Low capacity utilisation has been a global feature after the GFC, and not only in Japan. Focusing on just labour in the chart may over-estimate improvements in the economy.
Medium to long-run constraints:
- The slope of the long-run Phillips curve is vertical or extremely steep (economic policy is unable to sustain the trade-off between short-term improvements in prices and unemployment).
- Potential growth influences the location of the Phillips curve. A rise in potential growth accompanied by an upward shift in the Phillips curve. Similarly, a fall in potential growth is accompanied by a downward shift in the Phillips curve.
There is a general over-estimation of the utilisation of factor inputs (labour/capital) as it does not take into account voluntary job leavers, work-sharing by part-time workers and low utilisation of capital.
Japan is at the steeper part of the Phillips curve but the probability of Japan remaining there has been steadily falling since September 2015.
A decline in potential growth:
In the long run, inflation is influenced by:
- Growth of broad money aggregates
- Nominal GDP
- Potential GDP
Over the past 21 years growth rates of these indicators have been lower compared to other developed countries.
A decline in potential GDP corresponds to a downward shift of the Phillips curve, thus accompanying a decline in terminal inflation.
A widely held argument in financial markets is that because potential growth declined in the US, economic expansion would easily cause the supply-demand gap to shrink enough to cause higher inflation, or that if Japan’s potential growth rose due to Abenomics, the supply-demand gap would struggle to shrink even with economic expansion and that deflation would continue. These stories however are one-dimensional and ignore the fact that the long-run correlation between potential growth and inflation is positive, not negative. For example, inflation in EM countries tends to be higher than in developed countries, partly because potential growth is higher in the former.
Structural changes in the labour market:
Increases in these contribute to the decline of nominal wages.
- the employment rate (via diminishing marginal returns on labour)
- part-time employment rate (including involuntary part-time workers)
- increase in female participation
- small amounts of immigration
- relative wages of manufacturers over non-manufacturers
The long run stable relationship between wages and labour productivity
Wage growth falls when the decline in labour productivity is structural rather than cyclical. This in turn lowers terminal inflation.
Summary
The probability of Japan hitting the 2% target inflation is rather low. The only hope is to keep an accommodative monetary policy such that businesses and households that need to borrow could continue to do so. That in turn could lead to a faster rise in broad money and economic activity (nominal GDP), resulting in a rise in prices. If maintained over the long run, it may lead to an expansion in factor inputs or faster technological progress. All of this will perhaps raise Japan’s potential growth.
EightAteEight 