Japan: Is deflation on the horizon?
Amid a chain reaction of credit anxiety, economic downturn and asset deflation, international financial policies have proven ineffective. Against this background, the prices of commodities and transportation, which had been the major source of...
Amid a chain reaction of credit anxiety, economic downturn and asset deflation, international financial policies have proven ineffective. Against this background, the prices of commodities and transportation, which had been the major source of inflation, have fallen sharply on extreme de-leveraging and a flight to cash. In May 2008 the Baltic Dry Index for highly-volatile dry bulk shipping rates rose 11.6 times compared with the level set in January 2002, but the October 2008 average (from October 1 to 23) is only around 20 per cent of the May 2008 average. In addition, the West Texas Intermediate (WTI) crude oil future price in the US has fallen below $70 a barrel from the recent peak, set in mid-July.
Although the fair price of crude oil is debatable, the steep rise in this price after the sub-prime loan crisis broke was probably at least partially due to speculative investment. Assuming the rise in oil prices from January 2002 to July 2007 (until just before the BNP Paribas shock) was fair on the back of the economic take-off of emerging countries, most analysts think the fair price of crude oil is $84 a barrel.
However, assuming that the currently-correcting price of crude oil drops as far below the trend price from January 2002 to July 2007 as it rose above the trend price from summer 2007 to summer 2008, oil prices could decline further. Weakening commodity prices may lead to Consumer Price Index (CPI) deflation.
A solution to the credit crisis would help banks, corporations and households to halt the shrinkage of their balance sheets, but economic growth is even more important. Japan has improved its balance sheet mainly on the back of a steady recovery of the global economy from 2002, but the global economy is now weakening. In our view, in order to escape the financial and economic dislocations stemming from the sub-prime loan problem, either prices will have to fall considerably to enable a self-sustaining recovery of demand in the US and Europe, or these areas will have to adopt broad policies to stimulate demand (a combination of monetary easing and fiscal stimulus). However, stimulative policies tend to be less effective under strong pressure for further balance sheet corrections.
Thus, the current financial and economic turmoil may persist for some time, causing the prices of oil and other commodities to weaken further. Aiming to stabilise inflationary expectations, the Bank of Japan (BoJ) has warned of the possibility of second-round effects of commodity inflation. However, wage inflation has stayed low and total cash earnings are falling year-on-year.
Japan's core CPI in August increased slightly and is estimated that CPI year-on-year inflation peaked in September but will slow down hereafter. Inflation of over 2 per cent year-on-year can mostly be explained by higher prices for foods, gasoline and kerosene. The recent sustained drop in commodity markets and sharp increase in the effective exchange rate of the yen indicate that CPI deflation, rather than second-round inflation, is the main price concern. Prices for manufactured goods, which rose reflecting rises in commodity prices, will likely decline following a drop in the commodity markets, given the expected decline in demand for those products amid a slowing economy.
Looking at the relationship between crude oil prices in the US and gasoline prices in Japan, CPI-based gasoline prices have lagged crude oil prices by around two months. Based on this, if crude oil prices fall to $30 a barrel, the average gasoline price in Japan in 2009 will likely drop 11 per cent, pulling down all Japan CPI year-on-year inflation by 0.3 percentage points.
As the contribution of gasoline and kerosene prices to CPI inflation in August was 0.9 percentage points, gasoline and kerosene products alone would lower Japan CPI year-on-year inflation in 2009 by 1.2 percentage points (0.3+0.9). Given the possibility for food prices to fall, a rising deflation risk due to a growing gap between supply and demand, and sustained appreciation of the yen against the US dollar and the euro, Japan's CPI could fall in 2009.
However, according to a quantitative model developed by the Cabinet Office of Japan, if the value of the yen increases 10 per cent against the US dollar, real GDP would be pulled down by 0.3 percentage points, the annual GDP deflator growth by 0.3 percentage points, and real exports by 1.4 percentage points. The effective exchange rate of the yen against the US dollar has sharply increased.
Nevertheless, trade statistics show that around 50 per cent of total export transactions are denominated in US dollars and around 40 per cent in yen, while around 70 per cent of total import transactions are denominated in US dollars and around 20 per cent in yen. Accordingly, appreciation of the yen against foreign currencies other than the US dollar is unlikely to severely impact the Japanese real economy much, based on the above-mentioned quantitative model.
Market analysts are of the opinion that the major problem for the Japanese economy is the risk of a deflationary spiral, but excessive concern about a decline in Japan's CPI inflation, in reaction to the commodity bubble, is not necessary. Lower commodity prices may help to stabilise the bond market amid the shift from inflation to deflation.
This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.
Although the fair price of crude oil is debatable, the steep rise in this price after the sub-prime loan crisis broke was probably at least partially due to speculative investment. Assuming the rise in oil prices from January 2002 to July 2007 (until just before the BNP Paribas shock) was fair on the back of the economic take-off of emerging countries, most analysts think the fair price of crude oil is $84 a barrel.
However, assuming that the currently-correcting price of crude oil drops as far below the trend price from January 2002 to July 2007 as it rose above the trend price from summer 2007 to summer 2008, oil prices could decline further. Weakening commodity prices may lead to Consumer Price Index (CPI) deflation.
A solution to the credit crisis would help banks, corporations and households to halt the shrinkage of their balance sheets, but economic growth is even more important. Japan has improved its balance sheet mainly on the back of a steady recovery of the global economy from 2002, but the global economy is now weakening. In our view, in order to escape the financial and economic dislocations stemming from the sub-prime loan problem, either prices will have to fall considerably to enable a self-sustaining recovery of demand in the US and Europe, or these areas will have to adopt broad policies to stimulate demand (a combination of monetary easing and fiscal stimulus). However, stimulative policies tend to be less effective under strong pressure for further balance sheet corrections.
Thus, the current financial and economic turmoil may persist for some time, causing the prices of oil and other commodities to weaken further. Aiming to stabilise inflationary expectations, the Bank of Japan (BoJ) has warned of the possibility of second-round effects of commodity inflation. However, wage inflation has stayed low and total cash earnings are falling year-on-year.
Japan's core CPI in August increased slightly and is estimated that CPI year-on-year inflation peaked in September but will slow down hereafter. Inflation of over 2 per cent year-on-year can mostly be explained by higher prices for foods, gasoline and kerosene. The recent sustained drop in commodity markets and sharp increase in the effective exchange rate of the yen indicate that CPI deflation, rather than second-round inflation, is the main price concern. Prices for manufactured goods, which rose reflecting rises in commodity prices, will likely decline following a drop in the commodity markets, given the expected decline in demand for those products amid a slowing economy.
Looking at the relationship between crude oil prices in the US and gasoline prices in Japan, CPI-based gasoline prices have lagged crude oil prices by around two months. Based on this, if crude oil prices fall to $30 a barrel, the average gasoline price in Japan in 2009 will likely drop 11 per cent, pulling down all Japan CPI year-on-year inflation by 0.3 percentage points.
As the contribution of gasoline and kerosene prices to CPI inflation in August was 0.9 percentage points, gasoline and kerosene products alone would lower Japan CPI year-on-year inflation in 2009 by 1.2 percentage points (0.3+0.9). Given the possibility for food prices to fall, a rising deflation risk due to a growing gap between supply and demand, and sustained appreciation of the yen against the US dollar and the euro, Japan's CPI could fall in 2009.
However, according to a quantitative model developed by the Cabinet Office of Japan, if the value of the yen increases 10 per cent against the US dollar, real GDP would be pulled down by 0.3 percentage points, the annual GDP deflator growth by 0.3 percentage points, and real exports by 1.4 percentage points. The effective exchange rate of the yen against the US dollar has sharply increased.
Nevertheless, trade statistics show that around 50 per cent of total export transactions are denominated in US dollars and around 40 per cent in yen, while around 70 per cent of total import transactions are denominated in US dollars and around 20 per cent in yen. Accordingly, appreciation of the yen against foreign currencies other than the US dollar is unlikely to severely impact the Japanese real economy much, based on the above-mentioned quantitative model.
Market analysts are of the opinion that the major problem for the Japanese economy is the risk of a deflationary spiral, but excessive concern about a decline in Japan's CPI inflation, in reaction to the commodity bubble, is not necessary. Lower commodity prices may help to stabilise the bond market amid the shift from inflation to deflation.
This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.