Japan’s CPI inflation could accelerate to 1.9 per cent year-on-year in April according to our calculations, with energy accounting for 1.5 per cent and food prices contributing the remaining 0.4 per cent. After peaking mid-year, we expect CPI inflation in Japan to fluctuate between 1 per cent and 1.5 per cent. In other words, energy and food prices should have very little spillover effect on other sectors.
Despite some labour market tightness in Japan, an acceleration of wage growth as seen in the US is highly unlikely. In Japan, roughly half of the labour force are regular workers with long-term contracts whose compensation is revised only gradually. In addition, Japan experienced deflation for 15 years so people’s inflation expectation is very low.
Short-term and long-term interest rates are expected to stay low in Japan over the next two years. This would make Japan’s financial market unique among developed economies as low interest rates continue to make some risk assets interesting such as real estate and J-REITs.
Downside risks as rising commodity prices weigh on consumption
If commodity prices rise much more than our current assumptions, it could lead to a significant deterioration of Japan’s trade balance. In that case, the yen could decline much more sharply than we are expecting. In such an event, a 10 per cent depreciation in the yen could push up Japan’s inflation by 0.3 per cent to 0.4 per cent.
As things stand, we are expecting only a 5 per cent to 10 per cent decline in the yen, but if it depreciates by more than 30 per cent that would push Japan’s inflation higher.
If that were to occur, CPI inflation could stay somewhere between 1.5 per cent to 2 per cent, and that could be a reason for BoJ policymakers to consider more material changes to monetary policy, potentially changing the landscape of Japanese financial markets significantly.
In addition, as a country that imports most of its commodity supplies, the depreciation in the yen at a time when commodity prices are rising is effectively a consumption tax on Japanese consumers, which decreases their purchasing power. A further rise in commodity prices could result in weaker consumption.
However, this focuses only on the short term, and little attention has been paid to the significant capital gains on Japan's external assets (mostly denominated in foreign currencies) as a result of a weaker yen. Japan is the world's largest net foreign asset holder, which provides a macro hedge against the yen's depreciation.
Upside potential: increase in business investment
We must pay close attention to the increase in business investment by private companies for three reasons.
