Will Japan's recent inflation lead to long-term economic growth?
The Bank of Japan (BOJ) just raised its key interest rate for the first time in 17 years, from -0.1% to a range of 0% to 0.1%, marking an end to negative interest rates. The move comes as large corporations raThe Bank of Japan (BOJ) just raised its key interest rate for the first time in 17 years, from -0.1% to a range of 0% to 0.1%, marking an end to negative interest rates. The move comes as large corporations raise wages following an increase in consumer prices. As the economy enters a “virtuous cycle between wages and inflation’ as said by the governor of BoJ, less stimulus will be needed to boost demand, allowing Japan to finally normalize its monetary policy.
Japan's Nikkei 225 index, a stock market index, hit a record high, signaling positive views on the economy by investors, but the economy still avoided a recession. This is contrary to global trends, with central banks raising rates to counter inflation, following earlier cuts and negative rates introduced during the pandemic.
Contrary to most economies, Japan has been facing deflationary pressures for the past 25 years. This has caused the economy to stagnate as falling prices can cause consumption postponement. The new trend of inflation and wage raises is considered good news as it implies that the economy now has a chance to bring back sustained growth, but only if productivity and domestic demand rises.
Current inflationary forces
The Japanese labor market has been tight, with an unemployment rate of 2.4% in January 2024. The reason is that the economy has been dealing with a shrinking labor force, which is caused by population ageing. Companies are struggling to find enough talent to sustain their operations. This gives employees bargaining power to demand wage raises.
The graph above illustrates the medium-run labor model. It can help use visualize how a tight labor market can lead to inflation. The price-setting curve indicates the real wage, namely the ratio of nominal wage relative to economy-wide price levels. While the wage-setting curve depicts the minimum level of wage required to motivate employees to provide enough effort at every level of unemployment. The corresponding level of unemployment at which the two lines intersects is the labor market equilibrium. At this equilibrium level, wages offered are just sufficient to maintain employment rents, which makes employment worthwhile for workers. There are no incentives for companies to raise wages. And workers have no grounds to request for raises as they do not want to lose their jobs. As labor costs for firms remain unchanged, there will also be no need for price adjustments, which also means that no inflationary nor deflationary pressures are introduced here.
A decrease in the size of labor force as seen in the current Japan situation shifts the wage-setting curve upwards. When less workers are available, the costs of joblessness decrease as workers can find a new job more easily. The equilibrium falls to a lower employment level as a result. This introduces a favorable bargaining gap for employees, leading to wage raises. The increase in labor costs can then be passed on to consumers, causing inflation.
The strengthened position of workers can already be observed in the spring negotiations this year. Many large firms have agreed on unions’ demands for pay rises. Rengo, the largest labor federation in the country which consists of employees of large corporations, announced that they successfully secured a 5.25% pay raise for the new April fiscal year ahead. Some companies are even exceeding union demands. Nippon steel, one of the country’s leading steel producers, will be offering a 14% increase, 2% more than what its employees’ requested. Wage negotiations are still being carried out now; however, the outcomes that are already published points to a significant increase in the employees’ bargaining power.
The hope now is that this wave of wage increase can stimulate domestic demand, leading to more growth. And with wage growth serving as an incentive for consumption, the government can now raise the interest rate without detrimental effects on consumption, pulling away the spending stimulus supported by the ultra-loose monetary policy.
Low interest rates previously implemented by the BOJ make borrowing cheaper, which stimulates investments and household spendings. The interest rate wasn’t just low but negative, meaning that institutions and savers would have to pay the bank to keep their money there. This in turn can increase demand for goods and services. As the aggregate demand rise in the short run, more money will be used to chase after the limited goods on the market and potentially spark a demand-pull inflation. Higher demand also supports economic growth by stimulating business expansion and job creation, raising the level of employment. This creates a bargaining gap which enables employees to ask for pay raises. Increase in labor costs is then reflected on the prices, causing inflationary pressures.
Conversely, higher interest rates can dampen borrowing and spending, which helps to control inflation by reducing aggregate demand. However, too high interest rates can hinder investment by raising the cost for borrowing and slow economic growth.
Central banks adjust interest rates to strike a balance between controlling inflation and promoting economic growth. It is in fact a tool for managing the economy and achieving macroeconomic stability.
Are wages really increasing?
Although the BOJ is starting to raise interest rates to promote saving, wages are expected to increase more than the prices. The outpacing is primarily the result of the spring wage negotiations, which have achieved a pay rise of approximately 5.28% due to labor shortage and increased bargaining power explained above. The wage increase is suspected to stimulate consumption and a slow but continuous inflation. However, a final verdict of increase in real wages is not guaranteed as prices during an inflation tend to experience upward pressure, keeping real wages constant over a long-term period. The main cause of upward pressure is a decline in corporate profits, which are due to increased labor costs.
In fact, Japan has been going through a real wage decline in the last 22 months and even after increased wages through the negotiations, the real wages fell, though not as dramatically as the year before. In January, nominal wages have risen by 2% compared to last year, which exceeded expectations set at 1.2%. On the contrary, real wages have fallen by 0.6% despite the increase in nominal wages, though this decrease was smaller than forecast. The growth in wages served as an incentive for the BOJ to raise their interest rates.
Additionally, data published in January revealed that household spending has fallen by 6.3% from last year even though wages grew in the same month. The consumer confidence index following the negotiations has remained mostly stagnant, indicating that consumers have not experienced significant increased satisfaction with their financial situation despite the relatively large pay raise that was reported.
There is still a significant amount of uncertainty surrounding whether wages will recover such that real wages become positive. Even though there was a fall in consumption, economists expect real wages to turn positive in the second half of the year due to factors such as increasing labor shortage as spending is expected to rise following the negotiations. However, some others hold a less optimistic view. Companies may take advantage of the increase in consumers purchasing power and raise their prices. Moreover, a new labor law, which restricts the use of overtime, can largely reduce the actual income of workers despite a growth in base pay. These factors can offset real wage growth, posing as obstacles for the real wage to turn positive.
Another concern that hinders the growth of consumers’ purchasing power is the differential of wage adjustments within different parts of the economy.
The strong wage growth reported as of now focused mainly on large corporations. For the economy to see a significant boost in consumption, wages for employees at small and medium sized companies (SMEs), which accounts for 70% of the workers in the economy, have to rise as well. However, it is reported that these firms, especially regional ones, face difficulties reflecting cost increases in their prices. They do not have enough power to negotiate with customers. In fact, some customers are even asking for a price reduction. In a poll conducted on SMEs earlier this year, 34.6% were not planning to increase wages while only 27.3% confirmed a wage raise. The remaining 38.1% had not yet decided. There is a lack of evidence to prove the existence of a strong trend of wage rise. Therefore, some are skeptical about whether economy-wide wage level can increase. Let alone outpacing inflation to increase purchasing power. Others share a more optimistic view, claiming that the worsening labor shortage will force the SMEs to raise wages in an effort to retain employees.
To conclude, if customers are unwilling to accept higher prices, wages won’t be able to increase for the majority of workers. Without a growth in purchasing power, people are unlikely to expand consumption, hindering the economy to get back on track for sustained economic growth.
Implications of increased inflation
Inflation after a very long period of deflation can be seen a positive for the economy, especially because low stable inflation is an economic objective for central banks. However, inflation may also reduce the purchasing power for consumers.
The wage increase Japan has seen was one of the largest in 20 years, but as previously mentioned the real wage is indeed shrinking. Many people were used to stable prices over the past 30 years and many products were associated with a certain price, the price increases are not welcomed by the public.
In addition, Japan is currently more than eight trillion US dollars in debt. Previously, negative interest rates and deflation would reduce the debt burden. However, with higher rates now this would mean for the first time in long time, the debt burden would be felt as the interest payments would rise. Another thing would be more expensive mortgages.
Japan's tight labor market is empowering employees to demand wage increases, which could potentially boost inflation. However, the extent of real wage growth remains uncertain in an environment of falling consumer spendings and household confidence. Moreover, the uneven distribution of wage growth across sectors, especially in small and medium-sized firms, presents a challenge to the broad-based economic recovery. Without synchronized wage increases across the economy, the potential for sustainable growth remains limited, emphasizing the importance of strengthening purchasing power to support consumption-driven expansion. Based on the information presented, it is unlikely that the current increased inflationary pressure would lead to sustained growth long term.