Japan has been known globally as an economy struggling to overcome long-standing deflation and deflationary mindsets since the late 1990s. Major central banks have attributed Japan’s deflation to insufficient monetary easing. To avoid the same problem and reduce the risk of deflation, the Federal Reserve promptly and without hesitation adopted unconventional monetary easing measures in the wake of the global financial crisis. The Bank of Japan followed suit in April 2013 when it adopted quantitative and qualitative monetary easing (QQE) under new Gov. Haruhiko Kuroda.
The main measures under QQE were purchases of various assets. The BOJ further experimented a negative interest rate and yield curve control. These measures were expected to raise aggregate demand and accelerate inflation through a decline in long-term interest rates with a commitment to achieving a 2 percent inflation target. Stock prices and the yen’s depreciation were also expected through a portfolio rebalancing effect and interest rate differentials.
Four years later, overvaluation of the yen and undervaluation of stock prices have been corrected. But, the impact on the real economy has not been as strong as initially expected. Compared with the first quarter of 2013, households’ current real consumption dropped a little. Business investment remains well below cash flows due to stagnant sales despite historically high profits levels. Underlying inflation remains at around zero percent, a reflection of unimpressive aggregate demand. In 2017, inflation is expected to rise mainly due to the weakened impact of the oil cost drop on prices, but it is widely expected that the BOJ is unlikely to achieve inflation of around 2 percent stably anytime soon.
Why is it taking so long for the BOJ to achieve 2 percent stably? A well-known structural factor is unfavorable demographics and associated low potential economic growth. Another important, but less known factor is the public’s lack of understanding of the 2 percent target and strong resistances against price hikes due to upward bias in perceived inflation and inflation expectations. The BOJ’s opinion survey consistently reported that 60 to 70 percent of respondents indicated they had either never heard of the target or they had heard about it but do not know much about it. Contrary to generally held beliefs, moreover, households’ mind-sets are not deflationary since their perceived inflation and long-term inflation expectations are always positive and far exceed the rate of change in the consumer price index even in a deflationary phase. Such upward bias has hardly changed even since the advent of QQE. Naturally, the majority of those who reportedly felt a price rise have constantly viewed such prices as unfavorable.
The situation is quite different in the United Kingdom, where a similar survey is available. The Bank of England survey reveals that around 40 to 50 percent of respondents have for years consistently indicated that the “2 percent target is about right.” Combining this with “2 percent target is too low” responses, the ratio rises to around 60 percent. Clearly, U.K. households are more aware of the 2 percent inflation target and feel it’s reasonable. This suggests that U.K. inflation expectations are largely anchored to the 2 percent target. Upward bias in price perception and inflation expectations is also much lower in the U.K. than in Japan.
Why are households’ price and inflation expectations so high in Japan? They are a reflection of long-standing stagnant income growth and anticipated tighter household budgets. Households are very sensitive to food price hikes and often reduce their overall real spending when food prices rise sharply. The survey also reveals that since 2013, households’ tendency to increase (nominal) spending compared with the previous year has risen due to increased costs of consumer goods and services — not because of an increase in income or an increase in expected future income. Regarding the spending over the next year, by contrast, households were always planning to reduce total (nominal) spending even in a deflationary phase — rather than postponing their spending — because of higher expected general prices. In these circumstances, firms find it difficult to raise their sales prices continuously.
Firms reveal deflation-oriented mind-sets in their cautious price-setting behavior, but this mindset cannot be seen in households’ behavior. Sudden higher prices generated by the yen’s depreciation and the consumption tax hike meant firms could not avoid raising sales prices in 2013-2015. Some of them managed to raise sales prices by providing higher value-added goods and services without a decline in real consumption. But many firms continue to make substantial efforts to contain price hikes. This behavior is consistent with the BOJ’s firm-level survey, in which about 70 percent of respondents have constantly chosen the “around zero percent” response on their planned sales price increases in the year ahead. Together with the “don’t know” response, the ratio has typically exceeded 80 percent.
These stories tell us that the truth about Japan’s deflation is far more complex than generally held beliefs, which typically attribute it to temporary insufficient aggregate demand. In fact, Japan’s deflation is more structural than cyclical. Without correcting households’ upward bias and increasing their tolerance of price rises, achieving 2 percent inflation stably seems a distant prospect.
Looking ahead, sustainable high corporate profits in conjunction with labor shortages may help improve households’ actual income and income outlook, and thus their tolerance of price rises, thereby helping to correct households’ upward bias. But more importantly, the government must tackle social security system reforms given the public’s concerns about life in retirement and the financial sustainability of national pensions. The lack of trust is reflected in the high non-payment ratio of premiums (over 30 percent) for many years — especially among the younger generation.
It may be time for the government to realize that simple prescriptions that combine monetary and fiscal expansionary policies will not cure Japan’s deep-rooted economic problems.
Sayuri Shirai is a professor of economics at Keio University, a former BOJ board member and the author of “Mission Incomplete: Reflating Japan’s Economy.”