In the last Global Economic Outlook, we said that “the outlook for Japan is poor.” This is no longer the case. In fact, the outlook for Japan has changed substantially as a result of actions following the recent election. There is now a significant chance that Japan’s economic performance will be much better than almost anyone expected just a month ago. What changed?
Following the landslide election of a government led by the Liberal Democratic Party, party leader Shinzo Abe promised to engage in substantially new policies. Specifically, there are three main elements to his plan.
First, Abe intends to move the Bank of Japan toward a much more aggressive policy. He has already appointed new leadership to the bank, which intends to engage in unlimited asset purchases until it achieves its new target of 2.0 percent inflation. Currently, there is deflation, which means that prices continue to decline. The problem with deflation is that it causes consumers to delay purchases, which in turn discourages businesses from investing. In addition, declining prices increase real interest rates. Thus, the cost of capital is higher than the nominal interest rate suggests. Finally, declining prices lead to an increase in the real value of debts. A combination of deflation and slow economic growth is the proximate cause of the huge increase in Japan’s sovereign debt-to-GDP ratio. Thus, a policy of creating inflation makes sense. Whether it can easily be achieved remains a question. Yet, in anticipation of the new policy, the Japanese yen has dropped sharply in value. Plus, anticipation of the inflationary effects of the new policy has resulted in rising equity prices in Japan.
Second, Prime Minister Abe intends to engage in more fiscal stimulus. This means he will not worry (as previous governments have) about the level of debt. Instead, he hopes to stimulate growth in order to eventually cause a drop in the debt-to-GDP ratio. He has announced the first tranche of what is expected to be several increases in spending.
Third, Abe intends to have Japan participate in the Trans-Pacific Partnership negotiations aimed at creating a Pacific-area free-trade agreement. The main aspect of this would be freer trade with the United States. With the exception of agricultural products, most trade between Japan and the United States does not involve high-tariff barriers. Instead, there are non-tariff barriers, which often involve restrictive regulations. As such, freer trade between Japan and the United States would necessarily entail deregulation of many domestic industries in Japan—and that is the point. Abe’s push for freer trade is a way to achieve political support for market-opening reforms.
Early signs of progress
Has the new policy regime made a difference? The answer is yes and no. The drop in the yen has not yet led to a boost in export growth. But it will, eventually. It usually takes some time for an exchange rate movement to have an impact on the volume of trade. Continued weakness in exports is reflected in continued weakness in industrial production. Yet again, this is likely to change when the effects of a lower yen work their way through the economy. The increase in equity prices, combined with expectations of higher inflation, evidently had an impact on consumer spending, which increased at a healthy pace in both January and February. Given the fundamentals, this was not expected. In addition, the well-known Tankan Survey found an increase in business confidence, but capital spending plans remain static.1
Will the new policy regime work? It is not yet clear, but the reaction of financial markets is promising.
What to expect
Will the new policy regime work? It is not yet clear, but the reaction of financial markets is promising. Rising equity prices and a declining yen will likely bear fruit. The problem, however, is that the new monetary policy may not necessarily achieve higher inflation. Many observers are concerned that Japan’s economy is running so far below capacity that inflation of 2.0 percent cannot be achieved within the two years that the Bank of Japan expects. The concern is that huge asset purchases by the bank will simply create asset price inflation (which is already happening) and will not result in the inflation needed to change economic behavior. On the other hand, consumer behavior has already started to change in response to a new policy regime. Moreover, the fiscal stimulus could bear fruit if implemented quickly.
However, other obstacles to growth are lingering. Japan faces growing competition from companies in South Korea, Taiwan, and China in its core industries of electronics and automobiles. It also faces a relatively weak level of global demand, especially in Europe. Thus, the potential for export growth, even with a cheaper yen, is limited. The new policies will need to have a sustained impact on domestic demand in order to significantly boost growth. The early impact on consumer spending is a good sign, but it remains too early to tell whether the policy will succeed.