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May 11, 2023

Why US inflation will slow and help the BOJ

Indirect support for the yen will help attain central bankers’ goal of “good” inflation.
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In-house blogger
Guest blogger
Tetsuo Harry Ishihara
Strategist, Macrobond consultant, and former adviser to Japanese regulators
All opinions expressed in this content are those of the contributor(s) and do not reflect the views of Macrobond Financial AB.
All written and electronic communication from Macrobond Financial AB is for information or marketing purposes and does not qualify as substantive research.

The Bank of Japan has faced a dilemma - the weak yen has complicated its desire to continue with the world's last policy of negative interest rates. Inflation has been high, driven by higher import prices as the yen lost value against the dollar during the Fed's historic tightening cycle.

Now, the BOJ may benefit from some of the easing trends in US inflation. Price rises stateside are driven by services, not goods, and some of these categories are easing in the consumer price index (CPI).

That changes the outlook for long-term rates in the US- and means a smaller yield gap between Japanese and US securities. That should stem outflows, help the yen, reduce the extent of imported inflation and give the BOJ time to engineer the virtuous, domestically-driven wage-price spiral of "good inflation" it's seeking.  

Let's first drill down into US inflation.

US disinflation drivers: used cars, health insurance and rent

US core CPI has been slowing, mostly led by goods. As the first chart shows, the biggest drag has been used-car prices. About a year ago, prices for used cars were surging by over 40 percent year-on-year as semiconductor shortages curtailed the production of new cars. These bottle necks have now eased.

Besides autos, goods inflation has slowed more generally as Kansas City Fed data shows supplier delivery times have improved.

In recent months, health insurance has taken over as the disinflation driver, as the next chart shows. From a 30bp positive contribution to Core CPI last September, it will trough at a deeply NEGATIVE contribution this September.

Health insurance is one of the more peculiarly calculated elements of the inflation basket. It’s not getting cheaper, per se; but every October, the Bureau of Labor Statistics (BLS) updates the calculation using the insurance industry's retained earnings. Thus, the month of September tends to be the turning point, as the dots in the chart show.

The current plunge mostly reflects adjustments for the “quality” of health insurance, or “bang for the buck.” These so-called hedonic adjustments are also made for goods such as televisions and computers. According to the bang-for-the-buck logic, lower retained earnings = insurers paid out more benefits = more bang = lower core CPI.

According to Chairman Powell and research from the Cleveland Fed, the cost of renting a home should provide another inflation drag. The shelter component makes up approximately 40 percent of core CPI, and has by far the largest weight. However, the data is very backward-looking and heavily affected by existing tenant leases.  

As the next chart shows, Fed research reveals that inflation for new tenant leases has slowed sharply – which is important because new leases lead the BLS data by about a year. Thus, a sharp slowdown in the BLS shelter component should appear later this year, dragging core CPI down by a point or two. Core personal consumption expenditures (PCE) will also be affected via the near-equivalent “housing” line, but to a lesser extent, as the weight of housing in that measure is approximately 20 percent.

How about inflation in Japan?

Headline CPI figures show that inflation in Japan is largely led by goods. This is in sharp contrast to the US, where goods inflation has almost vanished and price increases are dominated by services, as the next chart shows.

The low services inflation in Japan is the result of decades of sluggish wage growth. According to the BOJ, this may change; wages are set to rise at the steepest rate in 30 years, driven by the trends I examined in my Macrobond blog last month.

Going back to rents: Japanese demographics have stagnated for the past 20 years, meaning that rent growth has hovered near zero. That has helped keep services inflation low. In the US, strong rent growth feeds into services inflation.

Food imports and energy subsidies

Post-pandemic, Japanese goods inflation was initially led by energy. That has been supplanted by food -- especially imported food. Japan imports about 90 percent of its energy and 70 percent of its calories. Global prices for both categories jumped after Russia invaded Ukraine last year.

In Japan, that shock was exacerbated by the diminishing purchasing power of the currency. The weak yen was driven by a widening 10-year interest-rate differential with the US. Consumers unhappy with soaring local prices blamed the BOJ for maintaining ultra-loose policies as the Fed tightened. Since the BOJ tweaked its yield curve control(YCC) policy in December, the yen has strengthened, helping tame inflation.

 Another disinflationary driver has been the government’s massive, 15-trillion-yen energy subsidies (about USD 115 billion). These resulted in lower utility bills for consumers and kicked in from about February, just in time for important local elections in late April.

As indicated in the next chart, these subsidies shaved off more than a percentage point from inflation through February and March.

This year’s looming inflation rebound (spurred on by a tourism boom)

The BOJ focuses on its particular version of core CPI, defined as headline CPI excluding fresh food (but including energy). Governor Ueda discussed his outlook for this indicator after the central bank’s policy meeting on April 27-28.

Chart-watchers often compare an indicator’s trajectory to a letter of the alphabet, describing a “U-shaped” or “V-shaped” chart. Ueda’s comments suggests the BOJ is expecting inflation to be shaped more like a “J” turned backwards, or perhaps an “L” or a fish hook. 

As we have discussed, inflation is expected to slow through September on the back of easing import costs, a stronger yen and the energy subsidies. However, as the two following charts imply, two factors are expected to push inflation back up again later in the year.
Firstly, foreign tourism and business visits  to Japan have rebounded strongly. In turn, that helps close the output gap from being deflationary towards being inflationary. That growth (combined with record wage growth) is expected to hoist inflation back up from October, but not all the way back to previous increases.

Put another way, the BOJ is hoping that the current bout of “bad” cost-push inflation will change to “good” demand-pull inflation.

Why slower US inflation helps Japan

By lowering – or at least capping – US long term rates, the US inflation slowdown should help the BOJ via a stronger yen from a tighter US-Japan rate differential.

Uncertainty around credit conditions stemming from recent US bank failures could lower US rates, as well. After the Silicon Valley Bank crisis in early March, market expectations shifted from rate hikes to rate cuts, perhaps implying that credit conditions are currently a bigger driver of US rates than inflation or jobs.

Importantly, the May FOMC statement even hinted at a pause in rate hikes, which will prevent the differential from widening again. (In theory, long-term rates are driven by market expectations of average monetary policy over a given period.)

Why does a stronger yen help again? As we implied earlier, a stronger yen will cut import prices, including food and energy – the important drivers of “bad” inflation. Of course, a severe appreciation of the yen could hit Japanese stocks, but Ueda has implied that stimulative monetary policies will continue until “good” inflation has been attained.

Although the functioning of the bond market remains a challenge after ten years  of Abenomics-era interventions, the BOJ’s current priority is to nurture the economy’s green shoots, ie. higher wages, the return of foreign visitors, and the output gap improvement. It also means that Japan’s financial markets will continue to be supported by BOJ policies.

This article was published in conjunction with Japan Exchange Group (JPX) and the original can be found here.

Related posts from this author:

“Sustainable monetary easing and record wage hikes”, April 3, View post 

“As Ueda takes the helm of the Bank of Japan, do record wage hikes finally portend ‘good inflation?’”, April 5, View post

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