Isn’t Deflation Over Yet?

CPI has been rising for a considerable period of time

Inflation rate according to the headline consumer price index (CPI) has been positive since September 2021. Moreover, the rate has exceeded 2 percent since April 2022. It may seem obvious for many that Japan is facing inflation, just like other economies.

Government’s definition of deflation and the relevant indicators

However, the Japanese government still has not declared that deflation is over. That is because, the government has said that it will consider deflation to be over “only when the economy no longer sees sustained decline of aggregate prices and when there is no possibility of returning to such a situation” (March 2006, Cabinet Office). In order to judge the trend of aggregate prices, the government suggested that the following four indicators are of important; CPI, GDP deflator, GDP gap, and unit labour cost.

Let us check how these indicators are doing recently.

First is the CPI. This price indicator is important because it is directly linked to the purchasing power of the consumers. This had been on a declining trend since the mid-1990s with only some brief exceptions. Recently, it has started to rise at a relatively high pace as mentioned at the outset (Figure 1).

Second is the GDP deflator. It is important because it is an indicator of home-made inflation. While CPI could be influenced directly by import prices (such as energy), GDP deflator reflects price changes due to domestic factors such as unit labour cost and/or unit profit. This had stayed broadly flat for a long-time but started to show an increase by more than a percent for three consecutive quarters (Figure 2).

Third is the GDP gap. It is defined as a difference between the real GDP and the potential GDP relative to potential GDP. It corresponds to the magnitude of the upward pressure on aggregate prices from the demand side (a demand-pull factor). It is notable that GDP gap has also turned positive, though slightly by 0.1 percent, in the most recent quarter (Figure 3).

Fourth is the unit labour cost. This tries to see the pressure on aggregate prices from the supply side (cost-push factor). Increase in wage will be favourable for the increase in household consumption, which, in turn, should contribute to the increase of CPI. Since the outcome of this year’s “Shunto (spring wage round)” was relatively high, how unit labour cost would perform was watched with interest. Regrettably, it has continued to fall even in the second quarters of 2023(Figure 4).

Deflation is not over yet according to the government’s definition

Above observation shows that the four indicators, which are considered by the government to be important for the judgement whether the economy is still in deflation or not, is still not providing a consistent message that deflation is over. CPI and GDP deflator has been increasing and the GDP gap has also turned positive in the last quarter. However, unit labour cost is still falling.

According to the government, therefore, deflation is not over yet, despite the rapid increase in CPI. It will be made in the future when the wage increase is judged to be strong enough to push up unit labour cost. This should be the reason why the government is encouraging wage increase to be sustained in the future.

Timing and the consistency of the judgement

In concluding, two things need to be mentioned with regards the judgement about deflation.

First, we need to expect that declaration by the government that deflation is over could take some time.

It is partly because, in accordance with their definition mentioned earlier, the government needs to make sure that deflation will not return: They need to take into consideration the downside risks that the economy may face in the future, which is not an easy task. However, it is also because wage increase is not expected until next Spring, when the 2024 Shunto will take place: In Japan, it is only in Shunto that wages are set for the following year.

Second, whether the judgement of the government and the Bank of Japan will be consistent or not need to be watched carefully.

In the past, the Bank of Japan’s judgement has not necessarily been the same with the government. That was the case when the Bank withdrew zero interest rate policy in 2000, and quantitative easing policy in 2006. In 2000, the Bank made the decision after rejecting the government representatives’ request to postpone the decision until the next meeting (the maximum that could be done by the government representatives which have a different view from the Bank).

This time, the Bank of Japan is also emphasizing the importance of wage increase. Therefore, the judgement of the Bank seems to have been consistent with the governmant so far. However, we need to watch carefully whether it stays that way: otherwise, we may be caught with a big surprise.