Inflation may drive restructuring of Japan's economy

Sunflowers in full bloom welcome holidaymakers for the summer festival in Nogi, Tochigi in Japan. Photo by KAZUHIRO NOGI/AFP via Getty Images.
Sunflowers in full bloom welcome holidaymakers for the summer festival in Nogi, Tochigi in Japan. Photo by KAZUHIRO NOGI/AFP via Getty Images.

The Japanese economy stands out among G7 economies for its historically low inflation. Between 1992 and 2021, prices increased only six per cent in Japan compared to almost 80 per cent in the UK and more than 90 per cent in the US.

So far, this picture has not changed in the face of the latest global inflation surge. Many countries have recently recorded year-on-year inflation rates approaching 10 per cent, but Japanese inflation has risen by much less – from 0.1 per cent per annum in October 2021 to 2.6 per cent per annum in July 2022.

Japan has faced the same external inflationary pressures as other major economies – notably the food and energy crisis that has followed Russia’s invasion of Ukraine, and the impact of supply chain bottlenecks as the global economy recovered from the COVID-19 pandemic. However, there are two reasons why the impact on Japan’s inflation has so far been lower than elsewhere.

Tight state controls moderate some price rises

Firstly, Japan has a number of policies and economic structures in place which tend to limit price fluctuations, although these can also compromise economic efficiency in normal times.

Government regulation means electricity and gas prices can only be revised gradually, so utility providers adapt to this in part by taking out long-term contracts for the supply of gas and coal, effectively paying a premium for price stability. Petrol prices have also been subsidised since late January in an effort to offset price rises.

Similarly, the surge in international wheat prices linked to Russia’s invasion of Ukraine has initially had a more limited effect in Japan than elsewhere because wheat is mostly imported by a state entity which fixes the resale price for six-months at a time.

Some 85 per cent of the wheat consumed in Japan comes from the US, Canada, and Australia. In June the import price exceeded the resale price which is currently fixed until September, resulting in a subsidy to Japanese consumers on bread and noodles.

Moreover, while the new wheat resale price was expected to increase by 20 per cent for the period October 2022 to March 2023, the Japanese prime minister has decided to freeze the resale price.

It is unclear how much this move will cost the government as wheat prices have been falling over the past few weeks, but there is clearly the potential for this policy to give rise to a significant ‘bread and noodle subsidy’ depending on future market fluctuations.

Secondly, Japan’s overall economic recovery from the COVID-19 pandemic has been delayed compared with other G7 countries, with restrictions on economic activity being lifted more slowly. This has also helped limit inflation by delaying the post-pandemic increase in demand that many other countries have seen.

Partly due to these factors, the political impact of inflation in Japan has so far proved to be limited. The House of Councillors’ election on 10 July did see ‘cost of living’ as a new major issue, but it was not a game changer. As a result, the government has been able to continue with an ‘item-specific’ approach to tackling the crisis in preference to making lump-sum payments to every household.

However, the shift from near-zero inflation to significant and sustained inflation is likely to continue and there is no end in sight to the conflict in Ukraine. In this case, the Japanese economy could see long-term structural changes in at least three areas.

Power shift in the labour market

Over the past three decades, the assumption of effectively zero inflation has been deeply embedded in the Japanese economy. Pay rises linked to inflation were highly unusual.

But labour unions were nonetheless reasonably content over the period – which sometimes involved falling prices – because it is almost impossible to cut wages of permanent workers without filing for corporate bankruptcy.

As a result, the unions did not typically need to employ tough tactics to achieve stability or even increases in real pay.

By contrast, in a future with sustained positive inflation, employers will have more scope to link real pay rises for permanent workers to productivity performance and labour unions will have to work harder to match inflation rises in wage rates, particularly in the weaker performing economic sectors.

This in turn could partially diminish the advantage, from the employee’s perspective, of permanent employment over non-permanent employment. It will also force labour unions to pay more attention to the trade-offs between achieving long-term job protection and delivering real pay rises.

A new narrative on the exchange rate?

In most countries, there is typically a variety of views on the pros and cons of any given appreciation in the domestic currency, with some commentators highlighting the benefits for domestic purchasing power and inflation reduction, while others focus on reduced international competitiveness of industry.

By contrast, currency appreciation has traditionally been viewed negatively in Japan, reflecting the critical role of exports in driving growth. This has continued even after major Japanese corporates have diversified their production facilities internationally.

However, in the current crisis, the Japanese Yen has depreciated alongside the rise in inflation while net exports have not improved, doubling the pressure on living standards. It may result in a shift in public perspectives towards a more balanced view of currency appreciation.

Accelerated action on decarbonization

As with other major economies, the initial Japanese response to the Ukraine crisis has included subsidies on fossil fuels, with negative consequences for action on climate change. However, the longer-term impact could be very different.

Many of Japan’s nuclear reactors have been idle since the Fukushima nuclear accident in 2011, reducing the nuclear share of the country’s power generation from 25 per cent in 2010 to only six per cent by 2021.

But the combined effect of the cost of living crisis and the urgent need to decarbonize the economy may prove powerful enough to overcome the public’s trauma arising from the nuclear accident, leading to restarting more nuclear reactors.

As all three of these factors would be broadly positive for the long-term functioning of the Japanese economy, there is a possibility there may be, after all, a silver lining to the country’s current inflation surge.

Yasumune Kano, Visiting Fellow, Global Economy and Finance Programme.

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