Bank of Japan is Too Optimistic on Inflation

Jacob Hess

September 22, 2023

• Japan
• Monetary Policy
• Inflation

The Bank of Japan held its policy rate unchanged in the most recent September meeting after it made a slight change to its yield curve control policy in the previous meeting. The maintenance of ultra-loose policy is justified by the Bank of Japan’s insistence that “Japan's economy is projected to continue growing at a pace above its potential growth rate” while at the same time projecting that “the year-on-year rate of increase in the CPI (all items less fresh food) is likely to decelerate.” Coincidentally, we got an update on CPI inflation just a few hours before this announcement was made.

In August, Japan's headline Consumer Price Index (CPI) recorded a growth of 0.3% MoM and 3.2% YoY, a slight dip from July's 3.3% YoY. This decline was significantly influenced by a drop in Energy CPI, which decreased by -0.6% MoM and is now -9.8% lower YoY, marking its lowest annual increase since August 2016. Meanwhile, Food CPI rose by 0.4% MoM and 8.6% YoY, both rates slowing down from the previous month. Household goods CPI, which encompasses furniture and household utensils, saw a deflation of -0.8% MoM in August. Notably, Recreation CPI, a semi-proxy for services inflation, surged by 1.8% MoM, reaching a YoY rate of 5.0%, the highest since 1981.

The Bank of Japan's (BoJ) core inflation metric, which excludes fresh food from the CPI, increased slightly by 0.3% MoM, maintaining an annual rate of 3.1% YoY. This is consistent with rates reported in February, March, and July of this year, but down from January's peak of 4.2% YoY. When excluding both food and energy, the core CPI rose by 0.3% MoM and 2.7% YoY. Interestingly, this annual pace remains at its zenith, unaffected by the declining energy prices. Despite the decline in energy prices contributing to some progress on inflation in 2023, these prices are set to incline in the near future. The BoJ continues to view these inflationary pressures as temporary, even as the Japanese economy consistently outperforms expectations. The latest S&P Global Flash Composite PMI indicates that Japan's economy is still expanding, albeit at a modest rate, the slowest since February. Service sectors are driving this growth, even though the pace has decelerated to an eight-month low. The report also highlighted that Japanese manufacturing is experiencing a four-month high in input price inflation, with output price inflation remaining stable.

Given the current trajectory of growth and inflation, it's plausible that the BoJ might hike rates within the next year, potentially by the end of 2023. The bank's inflation projections are consistently overly optimistic, and inflation figures consistently surpass prior estimates. Significant changes in wage and employment data will be required to align with the BoJ's inflation narrative, especially as current indicators suggest a labor market that bolsters Japanese purchasing power. As it stands, the BoJ's commitment to an ultra-accommodative policy sets it apart from other developed nations.