Reality and Cause of Deflation in Japan

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1 Reality and Cause of Deflation in Japan ECONOMIC REPORT Deflation More Pervasive than It Appears and Misunderstandings as to Its Cause Prices are regarded as a benchmark to measure the soundness of economic activities. In particular, importance is attached to the consumer price index (CPI) as a benchmark of movements in the prices of goods and services related to household consumption. However, it is little known that the CPI as currently used in Japan does not accurately indicate the degree of deflation. Moreover, there are serious misunderstandings as to the causes of the economic stagnation and deflation in Japan. Therefore, below, we will explain the problems involved in the CPI currently used and the reasons why the deflation and economic stagnation in Japan have continued. Current CPI Does Not Accurately Reflect the Ongoing Price Drop First, let us look at Figure 1. The CPI for the October-December quarter of 212 as calculated and published by the Ministry of Internal Affairs and Communications was 98.9 against the base of for 25. In other words, the index declined only 1.1% over the past seven years. Roughly speaking, the CPI remained flat to slightly lower over this period. However, the personal consumption expenditure deflator (PCE deflator), which is calculated on the basis of globally common rules and which is a component index of the GDP statistics published by the Cabinet Office, stood at 93.6, meaning that this index declined 6.4% over the same seven-year period *1. The margin of drop is six times as large as that of the decline in the CPI. Why is there such a large gap between the margins of drop in the CPI and the GDP deflator? The greatest reason is the difference between the weighting methods used in calculating these two indexes. The CPI used in Japan is calculated using a fixed weighting system in which indexes for around 59 items are weighted-averaged in accordance with the volume weight determined every five years (currently, the volume weights determined in 21 are used). When this method is used, it is assumed that the consumption structure (as represented by volume weight) remains unchanged for up to five years. Therefore, when prices of durable goods such as electrical products continue to decline steeply and the volume weight of durable goods rises significantly as a result, the CPI does not accurately reflect the actual price trend. 1

2 To help you understand that, let us take up the case of phones and personal computers as an example. Several years ago, a typical household had only one or two personal computers, but now, each member of a household may have his or her own personal computer and mobile phone, with some people possessing two or more of them. Nevertheless, the CPI is calculated on the assumption that there are only one or two phones and personal computers per household. On the other hand, the GDP deflator is calculated on the basis of constantly updated per-household ownership ratios of individual items. It is obvious which method is more realistic. Figure 1 Gap between the CPI and the personal consumption expenditure (PCE) deflat CPI PCE deflator 14 25= A gap too wide to be ignored Source: Ministry of Internal Affairs and Communications, Cabinet Office Note: The CPI excludes perishable food prices (the same applies hereafter) (Year) A Change in Volume Weight Would Narrow the Gap Between the CPI and the GDP Deflator The relationship between the CPI and the GDP deflator will become clear if the updated volume weight used for the durable goods deflator, which is a component of the PCE deflator, and the weight used for the non-durable goods deflator *2 are replaced with the fixed weight used in calculating the CPI. As a result of the replacement, the PCE deflator would significantly shift upwards as shown in Figure 2 and the gap between the deflator and the CPI in the October-December quarter of 212 would narrow by 58% (1:a shift from the blue line at the bottom to the red line second from the bottom). The upward shift of the deflator is due to the fact that whereas the weight of durable goods for the CPI is fixed at 6.6%, the weight for the GDP deflator in the October-December quarter jumped to 2

3 13.4% from 8.8% in the January-March quarter of 25 (the CPI tends to give an inflated reading because the weight of products whose prices are dropping steeply is small). Moreover, if the durable goods deflator, which is one of the two deflators constituting the PCE deflator, is replaced with the durable goods CPI, the PCE deflator would shift further upward and the gap between the deflator and the CPI would narrow by 14% (2:a shift from the red line second from the bottom to the green one-dot chain line). That is also because the CPI, for which the volume weight of each item is fixed, gives an inflated reading *3. Figure 2 The gap narrows if the weighting method used for the PCE deflator is replace with the fixed weighting method used for the CPI CPI PCE deflator PCE deflator calculated using the fixed weighting method PCE deflator calculated using the fixed weighting method and the durable goods CPI 13 25= (Year) Source: Ministry of Internal Affairs and Communications, Cabinet Office *1 The deflator, which is essentially a price index, is so called because it is a real price value arrived at by deflating a nominal price value. *2 Regarding the CPI as published by the Ministry of Internal Affairs and Communications, priced items are classified into durable goods, semi-durable goods, such as clothes and footwear, non-durable goods, such as foods and miscellaneous goods, and services. For the sake of simplicity, in this paper, we treat semi-durable goods, non-durable goods, and services collectively as non-durable goods. *3 The durable goods CPI in the October-December quarter of 212 is as much as 2.5% higher than the durable goods deflator. It should be noted that the Laspeyres chain index, 3

4 which is calculated on the basis of the volume weight for the previous year, is published as a way to correct the abovementioned problem. However, under the recent circumstances, in which the nominal weight remains little changed while the volume weight is increasing significantly, the Laspeyres chain index tends to give an inflated reading. In the FAQ concerning the CPI on its website, the Ministry of Internal Affairs and Communications states that the CPI and the PCE deflator are showing similar movements, a description that indicates a lack of awareness about the gap between the two indexes. Why Is Japan Alone Trapped in Deflation? There are also misunderstandings as to why Japan alone is trapped in deflation. The greatest cause of the deflation is a lack of demand, which in turn is attributable to the fact that emerging countries such as China, South Korea and Taiwan have come to manufacture inexpensive high-quality electrical products by introducing new equipment and by taking advantage of their cheap labor. While competing with emerging countries, Japanese electrical machinery makers have been forced to lower their export prices. In addition, an influx of foreign products has reduced their domestic sales, and as a result, overall earnings and demand in Japan have declined, leading to continuous price drops. Explanations like this have been rejected as incorrect on the ground that unlike Japan, other developed countries are not experiencing price drops. Instead, inadequate monetary easing and the aging of society are erroneously regarded as the cause of the deflation and economic stagnation in Japan. However, Japan is the only developed country whose electric machinery makers have been struggling because of the onslaught of competition from emerging countries. General Electric of the United States, which is known as a company founded by Thomas Edison and which was previously the largest electric machinery maker in the world, has already shifted its focus to the aircraft and nuclear industries, after facing intense competition with Japanese manufacturers. Other U.S. companies such as RCA (Radio Corporation of America), Motorola and Zenith no longer exist for reasons such as because they failed or were acquired by Japanese companies. The situation is similar in Europe. Consequently, whereas electric machinery accounts for as much as 19.5% of Japan s nominal exports, equivalent products in the United States (computers and peripherals) take up only 2.3% of the overall U.S. exports (in the October-December quarter of 212). This situation is confirmed by Figure 3, which shows movements of Japanese and U.S. import and export prices and the terms of trade for Japan and the United States as 4

5 represented by the ratio of export prices to import prices. The higher this ratio is, the more favorable the trade environment is. Although the term terms of trade may sound incomprehensible to people who are not familiar with it, the following explanation will help to understand it. The higher a company s sales prices are relative to purchase prices, the higher its profitability is. Likewise, the higher a country s export prices are relative to its import prices, the higher its revenue is (vice versa), leading to increased national affluence. Put simply, Japan has become poorer and has got stuck in deflation as its terms of trade have deteriorated. Figure 3 shows that Japan s terms of trade have deteriorated significantly since 2. Figure 3 Comparison between the terms of trade and import prices for Japan and the United States Terms of trade (=dollar-denominated export prices dollar-denominated import prices) Dollar-denominated export prices Dollar-denominated import prices 2= Japan 2= United States 16 First oil crisis Second oil crisis Continuing to deteriorate Dropping only slightly 4 4 Improvement of the terms of trade 2 2 Deterioration of the terms of trade (Year) (Year) Source: Cabinet Office, Bank of Japan, U.S. Department of Commerce Figure 4 shows why Japan s terms of trade have deteriorated. Japanese export prices have stayed lower than U.S. ones while Japanese import prices have stayed higher than U.S. ones. The reason why Japanese export prices have been lower is that Japanese electrical machinery makers face difficulty raising their export prices amid the onslaught of competition from their rivals in emerging countries. Meanwhile, Japanese import prices have been higher because Japan has had no option but to 5

6 purchase liquefied natural gas, which is relatively expensive compared with other fuels, as a result of the impact of the Great East Japan Earthquake. In particular, the difficulty of raising export prices is an important structural problem. The weight of electrical machinery, whose prices are on a downtrend, is very large in the Japanese economy, so Japan s terms of trade are likely to continue deteriorating as long as prices of electrical machinery keep on declining (a continued drop in prices of electrical machinery is inevitable given the ongoing advance in IT, and that is obvious to anyone in light of the increasing competition from emerging countries). Figure 4 Comparison of dollar-denominated import and export prices for Japan and the United States = Japan United States Dollar-denominated export prices (Year) Source: Cabinet Office, Bank of Japan, U.S. Department of Commerce Japan United States 2= Dollar-denominated import prices (Year) Since 2, Japanese export prices of electrical machinery and other machinery have been little different from, and in recent years, have been slightly higher than, U.S. export prices as shown in Figure 5. However, the volume weight of electrical machinery in Japan, at more than 3%, is far higher than the 5% weight in the United States as shown in Figure 6. Japan s terms of trade have deteriorated as export prices have not risen sufficiently because of the large weight of electrical machinery, whose prices have continued to drop steeply. When we examine the terms of trade, we may ignore the effects of exchange rates. That is because exchange rates affect both export and import prices, which are used as the numerator and denominator, respectively, of the calculating formula of the terms of trade (in other words, although exchange rate movements, such as the yen s appreciation and depreciation, may have significant effects on individual companies, 6

7 the impact on the economy as a whole is neutral). Figure 5 Dollar-denominated export prices Figure 6 Volume weight of electrical of electrical machinery and other machinery in Japan and the machinery made in Japan and United States (against the the United States base year of 2) Electrical machinery made in Japan Other machinery made in Japan Electrical machinery made in the United States Other machinery made in the United States 2= Other machinery Electrical machinery (Year) Source: Cabinet Office, Bank of Japan, U.S. Department of Commerce % Volume weight of electrical machinery in Japan Volume weight of electrical machinery in the United States Japan United States (Year) Significant Economic Impact of the Terms of Trade Changes in the terms of trade have had a significant economic impact, as shown in Figure 7. The figure shows changes in Japanese and U.S. real GDP caused by changes in the terms of trade in each country *4. At the time of the oil crises, Japan s real GDP was dragged down by more than 5% at maximum by the deterioration of the terms of trade. In , Japan s real GDP was pushed up by more than 5% at maximum by an improvement in the terms of trade. This was due to a steep rise in export prices induced by the recognition of the high performance of Japanese products. As the improvement in the terms of trade at that time was mistakenly recognized as evidence of an ever-lasting strength of Japan, economic bubbles arose in the country. Of course, economic growth has not been affected by the terms of trade alone. That was true particularly in the era of high economic growth. However, as Japan s growth potential has weakened while its affluence increased, the country s economic cycle has become inextricably linked with the terms of trade. After the turn of the century, 7

8 crude oil prices continued to rise amid the booming energy demand worldwide, putting downward pressure on the global economy. As the global economic crisis made it difficult to raise export prices, the terms of trade deteriorated significantly. In the past few years, Japan s terms of trade have deteriorated because of the difficulty of raising export prices and the upward trend of import prices. The major factor behind this situation is the rise of emerging countries. As a result of the rapid growth of emerging economies, Japan has become less competitive in export markets, while crude oil prices have risen on the import side. Figure 7 Impact of changes in the terms of trade on Japan s real GDP Impact of a change in the terms of trade four quarters before: b Real GDP growth on a year-on-year basis: a Impact of other factors: a-b 15 1 % Japan Improvement due to a steep rise in dollardenominated export prices ( ) Steep rise in crude oil price -5 First oil crisis Global economic crisis Second oil crisis Deterioration of the terms of trade (Year) % United States The terms of trade deteriorated. ( ) First oil crisis Steep rise in crude oil price Second oil crisis Global financial crisis (Year) Source: Cabinet Office, Bank of Japan, U.S. Department of Commerce Real Challenges for the Japanese Economy As shown above, the deflation in Japan is much more pervasive than is indicated by the CPI and its cause is a steep drop in export prices of electrical machinery, the main export item for the country, which has been triggered by the increasing competition 8

9 from emerging countries and which makes it impossible to offset the effects of a rise in import prices by raising export prices. The onslaught of competition from emerging countries is unlikely to wane in the future. Rather, we must accept it as inevitable that emerging countries will continue to rise one after another and attempt to overtake countries that have so far enjoyed economic prosperity. If so, what is most important is that companies facing the competition from emerging countries recognize that point and try to create high-value products that will be favored by foreign customers. It is also urgently necessary to save energy and develop new energy sources. Moreover, companies which have not been directly affected by the rise of emerging countries should also take action on the assumption that demand will remain stagnant and deflation will continue in Japan until the electrical machinery industry recovers. They should tackle fundamental challenges with a sense of crisis, including how to provide products and services that precisely meet users needs, expand sales channels from the global perspective and exert creativity. Policymakers must develop a price index that more accurately reflects the actual price trend and take appropriate measures in light of the abovementioned challenges. *4 Generally speaking, the impact of the terms of trade on real GDP is calculated by subtracting the impact on the import side from the impact on the export side. The impact on the export side is calculated by multiplying (i) the ratio of real exports to real GDP by (ii) the rate of change in dollar-denominated export prices. The impact on the import side is calculated by multiplying (iii) the ratio of real imports to real GDP by (iv) the rate of change in dollar-denominated import prices. The difference between the two represents the impact on real GDP. However, that alone is not sufficient, as the multiplier effect must be taken into consideration. For example, companies which have earned profits because of a rise in export prices distribute part of the gains to employees through wages, and as a result, consumption grows. The growth in consumption increases other companies earnings, which in turn expands consumption further, creating a feedback loop of profit and consumption increases. The ratio of consumption to income (consumption propensity) is approximately.6 to 1., which means that an increase in demand leads to an additional demand equivalent to 6% of the increase. The additional demand leads to a further increase in demand equivalent to 36% of the initial increase, which in turn creates an additional increase equivalent to 22%. Through this process, the feedback loop of income and demand increases eventually results in aggregate demand 2.5 times as large as the initial increase in demand (the same principle applies to recovery-related demand after the Great East Japan Earthquake). Therefore, the impacts on the export and import sides are calculated through the following formulas: (1) Impact on the export side (Year-to-year change in contribution to GDP, %)=(real exports real GDP ) (dollar-denominated export prices in the current period dollar-denominated export prices in the same period of the previous year-1) (1 <1-consumption propensity>) (2) Impact on the import side (Year-to-year change in contribution to GDP, %)=(real imports real GDP ) (dollar-denominated import prices in the current period dollar-denominated import prices in the same period of the previous year-1) (1 <1-consumption propensity>) 9

10 If calculated on the basis of the above formulas, the impact on real GDP over the 12 years from 2 is minus 16.2%. Given that the GDP deflator was pushed down by the same margin as real GDP, the decline in the GDP deflator (15.8%) over this period may be fully accounted for by the deterioration of the terms of trade. If looked at over a time span of 1 years, the correlation between the terms of trade and real GDP has been strengthening as a trend. The correlation in 2 and subsequent years is strongest when real GDP growth is compared with the terms of trade of four quarters before. That is presumably because it takes some time before the impact of changes in the terms of trade reaches end users. Other presumed factors include inventory-related time-lag effects on imports and the multiplier effect. Haruhiko Murayama General Manager, Tokyo Economic Research Division Kyoto Research Institute, Inc. FINANCIAL FORUM 213.SPRING The purpose of this report is to provide information, not to solicit the buying or selling of investment products. Information included in this report comes from sources regarded as reliable by the Kyoto Research Institute, Inc. However, the Kyoto Research Institute, Inc. makes no guarantees as to the accuracy and completeness of the information. Customers themselves are responsible for making final investment decisions. 1