Both headline and core inflation fell in Japan in December (see Chart 1). The core index, which excludes fresh food prices and is the measure preferred by the Bank of Japan (BoJ) to assess underlying inflation trends, rose 2.3% year-on-year. This is only just above the BoJ’s 2% inflation objective and is far below the 4.3% year-on-year peak registered in January 2023.
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Falling inflation: a potential problem for Japan
Japanese inflation has been falling over the past year, yet markets expect the Bank of Japan to exit its negative interest rate policy and yield curve control framework later this year. In this Macro Flash Note, Economist Sam Jochim looks at the implications of December’s inflation release for Japan’s monetary policy.
Chart 1. Japanese CPI inflation (% change, year-on-year)
Source: LSEG Data & Analytics and EFGAM calculations. Data as at 19 January 2024.
Much of the decline has resulted from falling energy prices, which enter both the headline and core indices in Japan. This is highlighted by the fact that the core-core index, which excludes fresh food and energy prices, has been falling at a gentler pace.
The spike in inflation in 2022 was driven by inflation abroad and a weaker yen, both of which resulted in higher import costs and caused a large increase in goods prices in Japan (see Chart 2). It makes little sense to increase interest rates when inflation is not being driven by domestic demand. The BoJ therefore appears justified in having stood firm on its policy.
Chart 2. Japanese goods and services inflation and import price index (% change, year-on-year)
Source: LSEG Data & Analytics and EFGAM calculations. Data as at 19 January 2024.
A decline in goods prices as import prices have fallen has dragged headline and core inflation lower. What’s more, the BoJ expects this trend to continue and believes that inflation could soon be below the 2% target.1 This begs the question as to why markets expect the first interest rate increase for 17 years in Japan in 2024 and an exit from the BoJ’s yield curve control policy.
The answer lies in services inflation (see Chart 2). This has been rising in Japan, though its overall contribution to headline inflation remains lower than that of goods.2 The BoJ believes that services prices are being pushed up by higher labour costs. Indeed, nominal wages are rising, though at a slower pace than inflation (see Chart 3).
Chart 3. Japanese nominal and real wage index (% change, year-on-year)
Source: LSEG Data & Analytics and EFGAM calculations. Data as at 19 January 2024.
This is key for the central bank’s policy. The BoJ believes that 2024’s Spring wage negotiations will likely lead to even larger pay increases than in 2023. If this also results in an increase in services prices as firms pass on the cost of higher labour, then the BoJ will be satisfied it is seeing a “virtuous cycle between wages and prices”.3
To summarise, if wages and services prices continue to rise and core inflation is around 2%, the BoJ will deem it appropriate to terminate the negative interest rate policy and yield curve control framework. Given the importance the BoJ places on the Spring wage negotiations, this decision is unlikely to be made before the meeting in April.
1 Summary of opinions at the monetary policy meeting on December 18 and 19, 2023: https://go.pardot.com/e/931253/inu-opinion-2023-opi231219-pdf/3vwgn/316778821/h/xOMyylbMhSm7ZDoAs4LVfFDOI6-g8vknPC1zTGWze38
2 EFGAM calculations show goods inflation contributed 1.4 percentage points and services inflation contributed 1.2 percentage points to the 2.6% year-on-year headline inflation in December.
3 See also, Summary of opinions at the monetary policy meeting on December 18 and 19, 2023: https://go.pardot.com/e/931253/inu-opinion-2023-opi231219-pdf/3vwgn/316778821/h/xOMyylbMhSm7ZDoAs4LVfFDOI6-g8vknPC1zTGWze38