An Attempt to Explain Today’s Lower Inflationary Pressures In Japan

In a world of soaring commodity prices, major commodity importers should worry about increasing inflation risks. Japan is the world’s fifth largest importer with at least its top 5 imports consisting of commodities: crude oil, coal briquettes, petroleum gas, refined petroleum, and iron ore. Yet, the Bank of Japan is not much worried about inflation risks. In an important speech on March 29, 2022 AMAMIYA Masayoshi, the Deputy Governor of the Bank of Japan, described inflation as a problem for the U.S. and Europe but not for Japan. In “The COVID-19 Crisis and Inflation Dynamics: Opening Remarks at the Workshop on ‘Issues Surrounding Price Developments during the COVID-19 Pandemic‘, Masayoshi offered several explanations for Japan’s lower modest 2% increase for its consumer price index (CPI):

• Japan experienced a limited shift in demand. In the U.S. in particular, a sharp shift from services to goods consumption created severe supply shortages which in turn helped drive up prices.
• A strong risk aversion in Japan limited pent-up demand for private consumption. As a result, Japan did not experience disruptive shifts in demand. Japanese conservatism has also anchored labor mobility, a key ingredient for the kind of wage pressures that can contribute to inflation.
• The waning of the pandemic has revived the Japanese corporate “norm” of deflationary thinking – the “assumption that prices will not increase easily.” Accordingly, unlike U.S. firms, Japanese firms prefer to focus on long-term business relationships and are reluctant to increase prices. According to Masayoshi, “When there are supply-side constraints for certain goods, U.S. firms tend to raise prices relatively quickly and allocate goods by giving preference to customers who are willing to pay higher prices. In contrast, Japanese firms seem to place more emphasis on long-term business relationships with customers and respond to their demand as much as possible while keeping selling prices unchanged.”
• Service prices remain relatively weaker in Japan (although Masayoshi called on a review of statistical practices).

Masayoshi concluded with the claim that “our understanding of inflation remains limited.” Despite this purported limited understanding, the Bank of Japan is quite confident enough to buy an unlimited amount of bonds to defend its ultra-low interest rates. Last week the BoJ surprised financial markets with this vigorous defense of its zero interest rate policy (ZIRP). The immediate reaction in the currency market sent an already rapidly weakening yen even lower. The rush to sell more yen created a (likely temporary) exhaustion of sellers. The yen rebounded for three days before selling resumed on Friday.

A divergence in monetary policy is helping to grease the skids for the yen. Last week, the Invesco CurrencyShares Japanese Yen Trust (FXY) plunged to an all-time low (since 2007).

As long as a differential in inflationary expectations exists between Japan and the U.S., the downward pressure on the yen should also persist.

Be careful out there!

Full disclosure: long FXY put options

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