Japan’s Virtuous Cycle: Progress on Wages, Consumption Lags

Summary

• The BoJ is hoping that loose financial conditions will promote the virtuous cycle where stronger wage growth leads to sustainably higher inflation.
• While progress has been made on the wage front, there is limited evidence that consumption is rising, or that underlying inflation will hold around 2%.
• Looking ahead, the impact of the income tax cuts and wage negotiations will be key.

Market Implications

• The BoJ will likely reduce the pace of JGB purchases this week from JPY6tr to JPY5tr.
• We don’t see the first hike occurring until September, while the bar is high for another hike later this year.
• However in 2025, the BoJ may be able to hike much faster than priced as the economy benefits from lower taxes, and rising real incomes.

What Is the Virtuous Cycle?

The BoJ’s last economic outlook mentioned ‘virtuous cycle’ seven times. The term has become increasingly key for describing the BoJ’s medium-term objectives and indicates how they intend to normalise monetary policy after years of zero interest rates.

But what exactly is the virtuous cycle?

The framework is simple. The BoJ intends to keep financial conditions loose enough to sustain underlying inflation around 2%. To do this, they must achieve:

1. Inflation expectations closer to 2%.
2. Rising wage growth.
3. Robust business fixed investment to boost productivity.
4. Strong household consumption in real terms.

Progress towards their target has already begun. In March, the BoJ ended its quantitative and qualitative (QQE) easing policy and slowly returned control of longer-term interest rates to the market. From here, the BoJ returned to focusing on the short-term interest rate as its primary policy tool and guided towards slowing monthly JGB purchases from the current rate of JPY6tn.

Where Are We Now?

This year has been challenging as temporary factors have prevented the BoJ and market participants from assessing the trend rate of growth and inflation.

Two major events significantly weighed down Q1 GDP figures: the January earthquake in Tokyo and the ongoing Daihatsu Motor car testing scandal. These factors resulted in a sharp, but temporary, decline in durable goods consumption.

Therefore, we need a granular breakdown of each data point to determine how closely it aligns with the BoJ’s framework.

Inflation Expectations

Over the past year, a weaker JPY and higher energy prices have driven steep goods price inflation.

The Tankan survey shows the initial impact: firms’ inflation expectations going out one and three years surged above 2%. As the initial shock eases, inflation expectations for one-year ahead are normalising. This has opened a divergence against the medium-term outlook (three and five years) that continues to rise. The challenge for the BoJ is understanding if the shift in the medium-term outlook represents a change in price-setting behaviour or is just a temporary dislocation.

More recently, market-based inflation expectations proxied via inflation breakevens have increased, even as oil prices have fallen and JPY has stabilised. Is the market beginning to reflect the BoJ’s framework into market prices?

Rising Wage Growth

Wages have seen significant progress. The country’s main trade union confederation, Rengo, reported wage growth surged to the highest level in three decades. Negotiations secured a significant 5.1% increase, surpassing the previous peak set in 1991.

The Rengo data is promising but only covers a subset of large firms (Honda, Toyota, etc.). The BoJ is now focusing on how it translates to small- and medium-sized business workers. As of the latest data, 40% of wage negotiations have concluded, with 80% to conclude by July.

Whether wage gains have been as strong for the broader economy is currently unclear. Total cash earnings ‘same sample’ – the BoJ’s preferred wage metric – slowed slightly in April to 1.7% from 1.9% in March. However, the pace remains well above the pre-Covid average of less than 1% growth (Chart 3).

When isolating full-time workers and excluding overtime and bonus pay, wage gains remain robust at 2.1% YoY. We think the BoJ will be happy to see wage growth stabilising at current levels (Chart 4).

Strong Household Consumption

For inflation to be sustainable, it needs support from the economy’s demand side. The BoJ hopes stronger wage gains translate to stronger consumption, but so far, the data does not support this.

Real household consumption per the BoJ’s timely measure is down 1% YoY in April, even as nominal spending flatlines around 2% (Charts 6 and 7).

Unfortunately for the BoJ, the latest data shows service-sector spending has also slowed from the elevated 2021-2023 pace while spending on non-durables has also been weak (Charts 8 and 9). Governor Adachi recently said consumers are becoming increasingly thrifty and shifting spend towards lower-priced goods as real incomes decline.

Weak real demand poses a challenge as can dampen labour market tightness. Traditionally, rising economic activity necessitates increased worker recruitment, which fosters stronger wage growth. However, this dynamic is currently absent.

Robust Business Fixed Investment

To sustain wage growth without pushing inflation above the BoJ’s 2% inflation target, boosting productivity will be key. Loose monetary policy can support business investment to ensure further wage gains are possible. Governor Ueda noted business fixed investment plans per Tankan have been rising in recent quarters, supported by digitalisation and decarbonisation. The latest capex data supports this, with the pace of capex growing strongly around mid-single digits.

Sustained Inflation at 2%

The BoJ seeks signs inflation is moving from cost-push to demand-pull. We see little evidence of that. A helpful BoJ paper suggests that items with the highest sensitivity to imports and the least sensitivity to wages have seen the fastest price increase. Meanwhile, the least volatile components, often services related, are only starting to see higher prices.

Also, in recent months, inflation momentum has eased considerably. Super-core inflation (ex. fresh food and energy) slowed to just 2.4% YoY in April, or 0.8% on a 3m annualised basis. The BoJ’s median forecast is around 1.7%.

Similarly, services inflation has also lost momentum. The trend has slowed from 2.2% in Q4 2023 to 1.7% in April.

This indicates that beyond the initial shock, Japan is struggling to sustain underlying inflation above 2% while real demand is weak.

What to Watch?

There are two catalysts to watch over the coming months.

June Tax Cuts

This month, the Japanese consumer will benefit from a JPY40k (c. $255) per person tax cut. The tax cut is split into two components, a JPY30k income tax cut and a JPY10k resident tax cut.

The Japanese government aims to provide households with an inflation-adjusted boost in income to sustain the virtuous cycle. The cut’s success will likely be key to providing the BoJ with more confidence in achieving their goals.

However, during this time, Japanese households will also face higher utility bills as the government removes subsidies.

The impact is much smaller, around JPY650, when combining the increase in electricity and gas bills, but could add up to 40bps to core inflation (CPI ex. fresh food).

Conclusion of Wage Negotiations

We also monitor the conclusion of ongoing wage negotiations. The BoJ will focus on this as smaller firms may be less able to pass on large wage increases than larger firms. This could limit the transmission from labour shortages to stronger wage growth.

The result of these negotiations will not be evident in the data until July when 80% of talks will have concluded, making the next two-three months of data critical for the BoJ.

Impact on Monetary Policy

Despite progress on policy goals, the BoJ still faces hurdles to boosting household spending and anchoring inflation around 2%. However, for monetary policy, we think BoJ will first reduce its pace of bond purchases from JPY6tn to JPY5tn this month, then wait for further progress later this year.

Given the tax cuts and wage negotiations will take time to show up in the data, the BoJ is currently guiding toward a rise in sticky prices during Autumn 2024:

‘If the aforementioned outlook for economic activity and prices will be realised and underlying inflation will increase, the Bank will adjust the degree of monetary accommodation’.

This makes the current pricing of an 80% chance of a 10bp hike in July optimistic. The BoJ is unlikely to have all the information required to be confident sufficient progress has been made. Two hikes could happen, but the data needs to corroborate. In this scenario, we think the second hike could occur in December versus market pricing of October.

Over the next 12 -18 months, we are optimistic that tax cuts coupled with recovering real incomes could help sustain consumption at a much stronger pace allowing for faster hikes next year.

A neutral rate at 1% nominal (-1% real) currently seems feasible. It also leaves room for a still-substantial shift in market pricing given the JPY OIS curve is currently pricing the 3m2y rate at around 50bps.

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Viresh Kanabar is an investment strategist with 8+ years of experience, notably contributing to portfolio construction and risk management at CCLA Investment Management, a £12 billion fund. Viresh was also a voting member of the Investment Committee and ran the private asset valuation process.

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(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)