Thursday, March 14, 2013

Why Hasn't Japan Gotten Inflation Yet?

The Japanese yen has fallen sharply in the latest year. The exact percentage differs of course depending on which currency you relate it to, but we're talking about a drop of about roughly 20% against the currencies of the three biggest currency blocs (The United States, the Euro Area and China).

That would normally sharply increase inflation, yet so far there is no sign of it. The yearly change in consumer prices remained below zero in January (-0,2%) and the preliminary estimate for the Tokyo area in February showed an even bigger price decline.

While pro- and antiinflationists disagree over whether more inflation is good or not, few, if any economists dispute that a sharp drop in a currency's value will, other things being equal, raise price inflation.

This is in part because a weaker currency will raise import prices. That will in turn raise consumer prices mostly because imported goods will become more expensive, but also because higher import prices will make domestic producers more likely to raise prices as their competitors prices have risen and as their input costs have risen.

But it is also because it raises nominal incomes of exporters, putting upward pressure on prices.

So why hasn't it happened yet?

One reason is that Japan is a surprisingly closed economy. Both imports and exports constitute only 15% of GDP, roughly in line (slightly higher for exports, somewhat lower for imports) with the percentage for the United States. By contrast, Britain and France for example have trade flows of about 35% of GDP and Sweden and Germany has trade flows of about 50% of GDP As a result, the aforementioned mechanisms will have a lot less impact on the overall economy than a similar sized devaluation would have in typical European countries..

A second reason is that many companies that engage in cross border trade purchases various derivatives to trade away short term exchange rate risk, meaning that the impact on consumer prices will come with at least a few months lag.

A third reason is that companies sometimes apply "pricing to market" principles. If they think that a currency drop will only be temporary they choose not to raise prices to avoid losing market share even if this lowers margins to unsustainably low levels. The companies reckon that if the currency recovers it could be difficult to win back market share so its best not to lose it in the first place. Ultimately the exchange rate movement will however pass through if it is sustained and if it's not the recovery will not result in price cuts so the weaker currency will make future inflation higher than it otherwise would have been.

So, we should still expect the yen weakness to push inflation in Japan back above zero. However, the increase will be a lot smaller than it would have been in a European country and comes with a significant time lag.