The latest Japanese CPI data showed that Japanese prices had fallen by 0.7% in the twelve months to April. Over the past two decades consumer prices have only fallen marginally on the CPI measure. The GDP and consumption deflators point to far more severe declines. This serves to highlight the challenge for Japanese policymakers.
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Japan has been stuck with stagnant or falling prices for around two decades, and one of the main policies of Abenomics is to hit a 2% inflation target. However, our chart illustrates how the broader GDP deflator measure of prices points to a far more severe decline of the order of 18% compared to a more modest decline in the CPI of around 3%.
Of course, the GDP deflator is not strictly comparable to the CPI due to coverage, with investment prices in particular causing large discrepancies. However, the consumption deflator should be broadly similar. The fact that the CPI and consumption deflator have differed so dramatically is largely because of the way in which the indices are formed. The headline CPI in Japan in formed by fixing the basket of goods and services that households consume using a Laspeyres formula index. As consumer patterns change, the basket is no longer representative and creates a bias in the index over time. This base weight for the CPI in Japan is updated every five years and over this period consumption patterns change. Revisions to base years are not applied retrospectively to historical data, beyond a period of around 18 months, so this bias is not corrected for.
The deflator, as a chain-linked Paasche index, does not suffer from these issues and hence a large wedge emerges between the two indices. Due to this formula effect, the focus on CPI inflation could underestimate the true extent of the problem of deflation in Japan. Deflation as measured by the deflator serves to highlight the real challenge that Shinzo Abe and Haruhiko Kuroda are facing up to.
The Minutes from the latest Bank of Japan meeting are indicative of the delicate balance, some would say contradiction, inherent in Abenomics. Although the Bank of Japan has the objective of guiding yields lower in order to enhance growth potential, Governor Kuroda appeared to confuse markets last week by acknowledging that, to the extent that the policy succeeds in reviving the economy, interest rates will tend to rise. The aim of large-scale bond purchases is to stimulate the economy by depressing yields to such a degree that inflation expectations rise, thereby pushing yields higher. Is it lower yields, or higher yields that are a sign of success?
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