Japan likely to return to slow growth in 2015

At the heart of the Japanese economy, there seems to be a conflict between the hope of policy and the reality of demographics. Japan's population is aging, not growing and the labour force is stagnant. Countries without any labour force growth lose a key contributor to economic growth, a factor that helped fuel their halcyon times of elevated growth. One can argue arithmetically (i.e., not causal) that long-term average real GDP expansion is the sum of the growth in the labour force and labour productivity. Take away labour force growth and one is left with the prospect of 1 per cent to 2 per cent real gross domestic product growth on average, unless there are major surprises in labour productivity. That is not to say it cannot happen, but a sharp and sustained upsurge in labour productivity is not easy for an already modernized and capital-intensive economy. Moreover, a depreciating exchange rate, quantitative easing, or an expansive fiscal policy are not likely to have a long-term, sustained impact on average growth in labour productivity.

Fears of deflation and growth prospects

Much of the logic behind Abenomics has been the concept that if the psychology of deflation could be beaten, consumer spending would increase at a more rapid rate and potentially drive real GDP growth back toward the higher levels of the 1970s and 1980s. Certainly, there is a case to be made that rising inflation expectations can bring consumption demand forward in time to beat the anticipated price increases. This pattern of economic behaviour was on full display before and after the April 1, 2014, rise in the national sales tax. Consumption and real GDP surged in the January-March 2014 quarter, only to be totally offset by a corresponding decline in real GDP in the post-tax April-June quarter. Indeed, the lagged impact of the sales tax extended into the modestly negative performance of the July-September 2014 quarter. The sales tax increase was a one-off event, and the tax-induced rise in inflation is quickly abating.

There is a similar one-off nature with rising inflation expectations. If inflation expectation ratchets up from, say, 0 per cent to 2 per cent, then there would be some incentive to advance spending plans, which might help real GDP grow a little faster for one year, after which spending levels would probably have adjusted to the new, and assumed, relatively steady rate of inflation. Only if inflation keeps rising will the incentive to increase current spending to avoid unexpected price increases remain in place. This approach to encouraging economic growth does not represent a sustainable plan.

Currency depreciation as the main weapon against deflation

Over the longer-term, sustained weakness in the Japanese yen (against the US dollar) is likely to be the main driver of inflation. The yen-dollar rate was in a trading range from 78-80 in mid-2012, prior to the election of Prime Minister Shinzo Abe in December 2012. His promise of more aggressive policies sent the yen-dollar rate to the 98-102 trading range by April 2013, where it remained for many months. As the promise of Abenomics faded in 2014, another round of yen weakness ensued, taking the yen-dollar to the 118-122 trading range. Compared to mid-2012, the yen has declined some 50 per cent against the US dollar from the yen-dollar perspective. This steep currency depreciation can work through the system with some important lags and eventually lead to an increase in measured inflation. This time around, the likely inflation increase from the currency depreciation may be partly offset by falling oil prices. Japan is a big energy importer so the sharp drop in crude oil can provide a partial counterweight to the falling yen.

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