Japan finally gets inflation—but the wrong kind

The head of Japan's central bank is a very patient individual. When Haruhiko Kuroda became governor of the Bank of Japan (BOJ) nine years ago, he pledged that he would rid the world's third-largest economy of the deflationary pressures that had helped keep growth slow ever since 1990. His goal was to pump in enough money to create a 2 percent inflation rate that would raise wages and spending power.

With commodity price inflation raising alarms globally, he finally looks set to achieve his goal. While the latest data is highly volatile, economists predict that Japan will finally start to see a 2 percent inflation rate—and possibly more—in upcoming months.

So far the figures remain tame by global standards. While the U.S. Consumer Price Index rose by 8.5 percent in March compared to a year earlier, the highest rate of increase since 1981, Japan's index was up just 1.2 percent. But that includes a 52.7 percent fall in mobile phone charges after a government crackdown on the three-company cartel that virtually controls the sector.

Other figures were eye-popping by Japan standards. Energy costs jumped 20.8 percent, the steepest rise since 1981, while cooking oil increased 34.7 percent. Another measure of inflation at the wholesale level, the Corporate Goods Price Index jumped 9.5 percent year-on-year in March, due in part to the dire situation in Ukraine.

Overall, economists reckon that after smoothing out the various one-time factors, underlying inflation is now around the target of 2 percent. Yet no one appears to be celebrating. Facing elections in June, the government is scrambling to formulate subsidy packages for those most affected, while the Japanese yen is falling sharply in value. Kuroda, however, appears unconcerned, calling the higher costs a short-term issue that will not deter him from his goal.

For Japan, the costs of more than two decades of deflation are clear. The country remains prosperous, safe, and comfortable, but what many Japanese have not noticed is that the rest of the world has been getting richer in absolute terms, while their country has largely stayed in place. Average annual wages have risen a mere 3 percent over the past 30 years, according to OECD data, compared to a 47 percent gain in the United States. Prices have followed a similar trajectory. Tokyo was for many years ranked as the most expensive city in the world, but Japan's capital today is not even among the top 10 in most global rankings, with cost cutting, a gradual lowering of tariffs, and greater import substitution helping to bring prices down.

To break out of this, the central bank has for the past nine years flooded the markets with cash, an unprecedented program that made it the buyer of virtually all new government debt. And with government tax revenues covering just 60 percent of spending in an average year, there is a lot of debt to be bought.

This creates two big problems. The Japanese government is the most indebted country in the world, with a total debt equal to around 190 percent of annual economic output. This backdoor financing of government largesse has meanwhile quadrupled the balance sheet of the BOJ to the extent that its own holdings rose to 92 percent of annual GDP in 2020, according to World Bank data, compared with 22 percent in the United States and 18 percent in Germany.

With all this, Japan today seems to have the wrong kind of inflation. The idea behind Kuroda's target was to create a so-called demand-driven virtuous cycle in which higher-paid workers go out and spend more, pushing up demand, leading to new investment and then higher wages.

Instead, the higher costs from overseas will push up prices and prompt consumers to buy fewer goods, not more. The problem is especially severe in resource-starved Japan, where virtually all raw materials and commodities are imported. That includes more than 60 percent of all the food consumed and around 95 percent of its energy, mainly through oil imports. With generally docile global commodity markets over the past decade, that has not been a huge issue until now, but both wheat and natural gas are in the crosshairs over Russia's invasion of Ukraine, and the problems are expected to worsen.

None of this is lost on a government looking to secure a stronger mandate in June elections for the upper house of Japan's parliament. While the ruling Liberal Democratic Party has no risk of losing control, the level of support in the second chamber is often seen as a gauge of voter sentiment about how things are going. To help cushion the blow of higher prices, the government is reportedly putting together a broad $48 billion package of subsidies to help consumers and small businesses. The assistance ranges from additional gasoline subsidies to low-interest loans and cash assistance, according to Nikkei.

At the same time, Japanese Prime Minister Fumio Kishida is using the price spike to help push his "new form of capitalism" designed to spread the wealth from the big companies and affluent retirees that have fared well under the last decade of Abenomics under former Prime Minister Shinzo Abe.

"To cope with rising prices, we will deploy every possible policy measure to protect people's livelihoods by enabling companies to pass on costs and creating an environment for them to raise wages for workers," Kishida told a parliamentary session in March.

Skeptics such as Credit Suisse economist and former BOJ official Hiromichi Shirakawa say that asking companies to raise wages even as other costs are going up is a pretty tall order. Japanese consumers have traditionally cut back on their purchasing whenever prices rise. This has made retailers leery of trying to hike prices in the past, leading to the concept of "shrinkflation," where smaller quantities hide higher unit costs.

Worsening the outlook has been a sudden fall in the value of the Japanese yen, which will make imported goods even more expensive. The yen is nearing 130 to the U.S. dollar, a fall of 10 percent since the start of the year. This will only deepen the economic divide Kishida is trying to narrow. Big companies with heavy overseas interests will reap sharply higher profits as they return their money home, while the average worker will end up paying more at the checkout line.

"As people's attention turns to higher imported inflation and a weaker yen, it will be necessary to reevaluate and weigh the merits and demerits of not only short-term economic stimulus but also the long-term adverse effects of locking in ultra-loose monetary policy," said Ryutaro Kono, chief Japan economist at BNP Paribas and a respected BOJ watcher.

For the longer term, the BOJ's biggest threat is an inflationary cycle that gets out of control. "If the public were to become convinced that the BOJ's policy stance is exacerbating the yen's slide and pushing prices higher, the bank could become the villain driving the increasing burden on households," Deutsche Bank Tokyo chief economist Kentaro Koyama said in a recent report. But raising interest rates, the traditional way to combat rising prices, would not just put the brakes on an already weak economy—it would also cause massive losses on the BOJ's holdings of government debt.

But Kuroda is not deterred, and the central bank has kept up its bond-buying program in recent weeks despite the worries over debt levels and the falling yen. His goal, he has always insisted, is to break Japan from the "deflation mindset." With price rises like these, he may well be on the way to success.

The question is whether these fresh worries, combined with Japan's aging society, shrinking workforce, and slow growth, will create a long-term and potentially irreversible downturn. While the outlook is problematic, Japan has defied the skeptics many times in the past. "Japan is the hardest economy in the world to understand," Citigroup's then-chief economist Willem Buiter said at a 2010 event. "If this were physics, then gravity wouldn't work in Japan."

William Sposato is a Tokyo-based journalist who has been a contributor to Foreign Policy since 2015. He has been following Japan's politics and economics for more than 20 years, working at Reuters and the Wall Street Journal. He is also the co-author of a 2021 book on the Carlos Ghosn affair and its impact on Japan.

Disclaimer: This article first appeared on Foreign Policy, and is published by special syndication arrangement.