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Japan’s deflated record on monetary policy

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Author: Willem Thorbecke, RIETI

Japan has used monetary policy to stoke inflation since Shinzo Abe became prime minister in 2012. But with inflation above 8% in the US and Europe and 10% in the UK, Japanese inflation averaged below 2% between January and July 2022. The question is why the Bank of Japan (BOJ) failed to meet its inflation target despite buying 400 trillion yen (2.8 trillion dollars) of government bonds over the past ten years.

Japan has a long history of monozukuri, or manufacturing. During the post-war period, companies such as Toyota, Panasonic and Sony became world-class manufacturers. Competition in global markets has forced them to innovate to meet consumer demand. Profits and wages rose as they succeeded – and the Japanese economic miracle emerged.

Many shocks then shook the Japanese economy. The global financial crisis has been particularly devastating. Japanese industrial production fell 35%, real exports fell 40% and the Nikkei 225 stock index fell 80% in the first two years of the crisis. The Japanese real exchange rate appreciated by 30%. It played a key role causing exports to fall and losing the price-competitiveness of Japanese companies, particularly in the automobile and electronics sectors.

To maintain competitiveness, many Japanese exporters kept export prices constant in foreign currencies. The strengthening yen pushed down yen-denominated export prices without lowering production costs in Japan. Export prices fell an average of 30% more than yen-denominated costs, crushing corporate profit margins. Japanese companies reacted by transfer of production abroad and manufacture high-end products in Japan.

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

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

The high-end products that Japanese companies now export, such as ceramic capacitors and image sensors, require advanced technologies and skilled workers. When the weaker yen boosts exports, it benefits highly skilled workers who already receive higher wages. Normal workers in export industries, which flourished during Japan’s post-war boom, do not benefit from these gains.

Large corporations such as Toyota find that the weaker yen increases the yen value of repatriated profits from overseas production and sales, thereby boosting their stock prices. Wage gains for highly skilled workers and rising stock prices primarily benefit those at the top of the income distribution. The weak yen does little to increase aggregate consumption because the marginal propensity to consume of rich workers is lower than the marginal propensity to consume of poor workers.

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

Its task is made more difficult by the reluctance of Japanese companies to raise prices in the Japanese market. Businesses have a strong sense of loyalty to their customers and fear losing customers if they raise prices. Even if it hurts their profit margins, companies often choose to absorb increases in input prices rather than increase the price of finished goods.

If the yen continues to weaken, this risks creating a vicious circle. A weakening yen against the US dollar raises the costs of imported energy and US dollar-denominated raw materials, increasing Japan’s trade deficit. Japan ran trade deficits every month between August 2021 and July 2022. The yen could depreciate further as the trade deficit feeds into the current account deficit. Japanese policymakers should be prepared to act if the depreciation becomes disorderly. The BOJ intervened on September 22 by buying the yen. But intervening in the currency markets without changing the interest rate differentials between Japan and other advanced countries is unlikely to strengthen the yen much over time.

Abe proposed three types of policies – monetary policy, fiscal expansion and structural reform – to revitalize the Japanese economy. He poetically called them the three arrows. In practice, policy makers have account on the arrow of monetary policy. While expansionary monetary policy caused the yen to depreciate, the weaker yen failed to boost wages or consumption. After Japan outsourced much of its manufacturing, the weak yen no longer boosts exports and no longer has the impact it once had on employment and wages for workers in the industry.

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

Willem Thorbecke is a senior researcher at the Japan Economics, Trade and Industry Research Institute.