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Japan's Economic Wounds Could Make It Oblivious to Inflation

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Kazuo Ueda, governor of the Bank of Japan, is aware of the dangers of abruptly tightening monetary policy. Since 1997, attempts by his predecessors to reduce stimulus and increase borrowing costs have continuously failed. Investors fear market turbulence if Ueda raises rates right away, but there's also a chance that he'll wait too long.

Ueda has enjoyed a calm market honeymoon since taking over from Haruhiko Kuroda in April. According to Refinitiv statistics, the Nikkei 225 large-cap stock index is the world's strongest-performing major benchmark, slightly outpacing the Nasdaq Composite, and the yield of the benchmark 10-year bonds has ceased pushing 0.5%, which is at the top of its trading range set by the BOJ.

This is due to investors' concerns that Ueda would have to immediately tighten monetary policy in response to growing inflation and a depreciating yen being allayed by his choice to maintain ultra-low interest rates for the time being. Due to rising currency hedging costs, this might have sparked a faster repatriation of cash that Japanese investors had stashed abroad in quest of higher profits. According to data from the Bank for International Settlements, Japanese entities possessed more foreign assets than any other nation by the end of 2022 — over $5 trillion.

Ueda has gained time to concentrate on analyzing macroeconomic fundamentals, particularly inflation, thanks to his silence and the supportive reaction of the domestic markets. His work becomes more challenging at this point.

If employees demand and receive raises to offset the increase in their living expenses, Japan may experience long-term inflation that calls for a gradual tightening of monetary policy. The situation is murky, which is unfortunate for Ueda. With some notable outliers, such as Fast Retailing, operator of the Uniqlo clothing brand, annual wage increases negotiated by the main unions in the nation in April averaged approximately 3%, which is strong by historical norms but below CPI. Additionally, a severe lack of workers in several industries is driving increasing non-union and informal wages.

It is important to keep in mind that Japan's economy formerly ranked among the world's frothiest. Between 1986 and 1991, a rippling export-driven economy propelled by industrial titans like Toyota Motor and Toshiba fueled wild speculation in domestic stocks and real estate.

The BOJ was aware of the issue as early as 1987, but its leaders were alarmed by the American stock market catastrophe on Black Monday. They didn't do anything for two years. The central bank officials caused a slump in land prices akin to the Great Depression in the United States in the 1930s when they started belatedly boosting rates. According to economist Richard Koo, declining values destroyed the equivalent of three years' worth of national GDP, or 1,500 trillion yen, about $9 trillion in 1990 dollars.

When the economy grew at rates between 3% and 7% every quarter in the 1980s, Japan was nowhere near as bubbly as it is today. In the three months that ended in March, output increased only 1.6% on a yearly basis, and there is little demand for Japanese goods abroad. Japan Inc. still has a sizable amount of uninvested reserves.

In a slow-growing, rapidly elderly country where cash hoarding has become reflexive, the possibility of a driven-by-demand inflation cycle still seems remote. Japan's bubble burst, making measures to reduce fiscal spending, raise consumption taxes, or increase borrowing rates foolish. Setting benchmark interest rates higher in 2000 was a terrible idea; long-term lending rates actually decreased as a result, and the decision had to be changed. The same may be said of Prime Minister's more recent experiment with hiking the consumption tax. Japan's "long-held deflationary mindset" is still a key goal of the government's most recent draft version of its long-term economic strategy.

However, the current state of the world economy has radically transformed, and persistent patterns like diversification in supply chains away from China appear to be maintaining steady upward pressure on prices. In that regard, a nation like Japan with a lot of retirees live on fixed incomes, would be especially badly hit by the combination of price increases and sluggish growth.

Price overheating has not yet been sufficiently demonstrated. However, recent events indicate that even if they succeed, time is running out. Policymakers who procrastinate might find themselves forced, as Western monetary authorities were, to drastically tighten policies in a panicked situation. Bond prices would fall, and the yen would sharply appreciate because it has dropped more than a fourth of its value against the US dollar since 2021. A spike in the yen would weaken Japan's exports and reduce the value of local currency international sales at significant exporters like Toyota, affecting profitability. Trillions of dollars of Japanese yen would most likely return home, resulting in a contraction of the economy, which the International Monetary Fund projects to be a meager 1.3% in 2023. In comparison to premature normalisation, this might cause a more severe worldwide shock.

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