The Nikkei Financial Daily (Market Eye Column)., 29th May 2007
Central banks try to estimate whether the current level of output is below its equilibrium level. If it is, there is an “output gap” and inflation should not pose an imminent problem. The next question for central bankers is whether output is growing fast enough to close this gap. If it is, then they will need to start raising interest rates before the gap closes. This is because it takes some time before changes in rates have an effect on the economy and, if the output gap closes while the economy is growing strongly, inflation will pick up.
The OECD estimated that Japan’s output gap had closed by the end of last year. It now seems that this was premature, since inflation, as measured by the CPI, has fallen back into negative territory and the growth in wages has slowed rather than accelerated. Judging from reports about the very small increases agreed in this year’s Shunto, a sharp rise in wages is now unlikely before next spring.
Employment is rising and, as the number of people available for work is falling, it seems that while there is an output gap, growth is fast enough to close it. Estimating the size of the output gap is very difficult, so it is not surprising that the OECD’s estimate looks to have been a bit premature. It would, however, be equally surprising if the OECD were completely wrong. It thus seems reasonable to expect that the output gap will have closed in time for next year’s Shunto, unless the economy slows unexpectedly.
To avoid inflationary pressures building up, the Bank of Japan will want the economy to start slowing by the time that the output gap has closed. If this is on track to happen next spring, this means that interest rates will need to be rising from around the autumn of this year.
The Bank of Japan faces two very difficult tasks. Firstly, it needs to slow the economy in a gentle way so that inflation does not pick up nor does the economy fall back into recession. Secondly, it must steer the economy away from being so dependent on exports and capital investment so that personal consumption takes an increasing share of GDP.
Japan has far the lowest level of consumption and far the highest level of investment of any G5 country. Exports require much more fixed capital for their production than the goods and services needed to satisfy domestic demand. So long as exports drive the economy, and interest rates are at near zero, the current high level of investment can be maintained. But this balance requires an ever rising trade surplus, which cannot be maintained.
In order to switch the economy from investment and exports to consumption, household incomes have to rise, not only in absolute terms, but as a proportion of GDP. There are two ways in which this can be done. One is to have real wages rising faster than GDP and the other is for interest rates to rise. Both of these routes present problems, as they both involve declines in the share of profits and, as Japan is a slow growing economy, a fall in the share of profits will, in the absence of rapid inflation, require an absolute fall in profits.
In practice we are likely to see household incomes rise in both ways. Increases should occur in both wages and interest rates. As incomes rise, so should consumption. But it is also likely that corporate investment will fall as profits decline.
No one knows whether these changes will offset each other to produce a nice balance or whether one will predominate over the other. If investment falls by more than consumption rises, the economy is likely to fall back into recession. If, however, consumption rises well then total demand will be too strong, inflationary pressures will be building up and further increases in interest rates will be needed.
It seems likely that the Bank of Japan will be more worried about a return to recession than the risk of inflation, so the first steps towards increased interest rates will be small and tentative.
But, in order to rebalance the economy in favour of consumption, the Bank of Japan will need to have wages rising faster than prices. This will be difficult at first, as it is usual for prices to move more sharply than wages when output gaps first close. The most likely way to avoid this would be to have a stronger yen, which argues in favour of having interest rates rise sharply.