If the Fed is getting nervous about the durability of the US recovery, Mr Abe has no such qualms about Japan which is, in his words: ‘for sure now on a solid growth and recovery path’. It seems increasingly likely that the VAT hike, currently pencilled in for April 2014, will be confirmed this week, probably with an accompanying statement about offsetting fiscal measures. Looking further ahead, however, it is the acceleration in import prices that presents the key threat to Abenomics. Inflation based on rising import prices could so harm real household incomes that it proves to be something of a Winner’s Curse.
At first glance, Japan appears to have set out on a path that will see it escape from deflation. Headline CPI inflation was 0.9% in the twelve-months to August, the strongest reading since November 2008. Core CPI inflation, which excludes fresh food, was 0.8%. However, much of the increase in inflation is of the ‘bad’ type, driven by higher import prices on the back of a weaker yen – ‘core core’ CPI inflation, which strips out food and energy costs, is still in negative territory, at -0.1%.
Accelerating import prices erode the disposable incomes of Japanese households, denting consumer sentiment and by extension private sector activity. Consumer confidence fell in August for a third straight month. Unfortunately higher import costs—particularly for energy— are unlikely to go away any time soon. Following a complete phasing out of its nuclear reactors, Japan will have to rely on imported oil and gas for the foreseeable future. Compared to electricity price inflation, already running at an annual 8.9% rate, a 300 basis point VAT hike seems like small beer.
Minister Amari has acknowledged that ‘an exit from deflation will become distant if we’re seeing cost-push inflation, where wages aren’t catching up with rising prices’. Japanese wage growth remains lacklustre, at best, so it hardly constitutes a boost to consumer confidence for the time being. While total cash earnings rose for the second straight month in July, by an annual 0.4%, this was predominantly on the back of overtime pay and bonuses, not contractual earnings. Real earnings—defined as total wages minus CPI inflation excluding imputed rent—actually fell by 0.4% in the year to July, suggesting that the weaker yen is taking its toll on the consumer.
At this juncture, the government is more likely than not to proceed with an increase in indirect taxation. But investors would do well to look through the VAT issue and focus on what is becoming an increasingly difficult problem for Mr Abe: while striking a fine balance between pursuing growth and fiscal discipline is a difficult task in its own right, sustained ‘bad’ inflationary pressures further complicate the government’s policy options. Particularly as the linchpin of a sustainable recovery—a pickup in real wage growth—remains largely elusive.