Global Economics

Japan's Inflation Conundrum


Could rising prices kick-start the world's second-largest economy?

Talk to almost any Japanese consumer, and you're likely to hear a litany of complaints about skyrocketing food and energy prices. Though such bellyaching might be common enough in other parts of the world, in Japan rising prices are something altogether new after a decade-long struggle with deflation.

So why, then, do some economists think a shift to inflation could boost Japan's economy? At first glance, the idea might seem far-fetched. The Japanese consumer is now paying nearly $1.70 a liter ($6.40 a gallon) for gasoline and has seen prices for staples such as soy sauce and bread go up 10% to 30% since last year. You would think people would be cutting back on spending.

But economists who see benefits in rising prices for Japan base their prediction on consumer expectations. When the country was struggling with deflation, consumers assumed prices would continue to fall. So they squirreled away cash and put off buying a new car or washing machine in anticipation of lower prices to come. Now that prices are going up, consumers might take the opposite tack, since they could end up paying more the longer they wait to buy something. "Inflation is Japan's dream come true," says Jesper Koll, an economist and CEO of Tantallon Research Japan.

Defying the Conventional Wisdom

Welcoming inflation is hardly the conventional wisdom, particularly as wage growth in Japan remains sluggish. But even detractors say the theory holds up after the country's long battle with deflation. For now, though, few Japanese seem to be rushing out to buy things. In May, household spending dropped 3.3% year over year, according to government statistics. "My shopping habits haven't changed much," said Mari Yamaguchi, a 30-year-old housewife in Tokyo. "I recently bought extra cereal, curry, and soy sauce, but we're limited to what we can buy because our house isn't big and we don't have much storage space."

Arguably, consumers have no reason to fear widespread inflation just yet. To be sure, the consumer price index posted a 1.5% rise in May, its biggest gain in more than a decade, but that was due to some one-time tax changes. And wholesale prices were up 5.6% in June, the most in 27 years, following May's 4.8% rise, according to Bank of Japan statistics released on July 10. But if you strip out volatile food and energy prices, "the CPI is still 0.1%," says Masaaki Kanno, chief economist at JPMorgan (JPM) in Tokyo. "At the moment there's no spillover effect to other items."

However, there are signs that price hikes may be in the offing. So far, companies have been absorbing higher costs for fear of losing customers to rivals, but that may not last. Last month, Japanese media reported that Toyota Motor (TM) may increase prices on all its domestic models in the coming weeks. The last time Toyota did that was in 1974. Toyota is Japan's biggest manufacturer and other companies could follow its lead. Nissan Motor (NSANY) CEO Carlos Ghosn said on June 24 that the automaker was near a decision on raising prices in Japan, and suggested that other carmakers, faced with soaring raw materials costs, are considering similar measures.

Cash Stash in Low-Interest Accounts

Even if consumers were to start spending freely again, where would they get the cash? Koll and others point to Japan's $14 trillion in household assets. Roughly half of that is stashed away as cash, mostly in low-interest postal savings accounts, which typically earn less than 1% per year in interest. Those low rates didn't matter so much during deflation as the value of consumer savings was still rising in real terms. But with the Japanese central bank holding key interest rates at 0.5%, the returns on savings in real terms are moving into negative territory.

Inflation could have other ramifications. It might convince consumers to shift funds away from ordinary postal and bank savings accounts into higher-yielding securities. Some of that might end up going to the private sector, instead of being channeled into unneeded public works projects.

The Corporate Angle

Investors, meanwhile, are hopeful that inflation can spur improved profitability at Japanese companies. In a recent note to clients, Virgil Adams, a senior research analyst at Matthews International Capital Management, predicted that inflation would spawn a kind of corporate Darwinism in Japan. Companies that can't pass on their rising costs to consumers might have to merge in order to gain scale and become more competitive, Adams wrote.

That's long overdue in sectors such as the pharmaceutical industry, with 1,200 different manufacturers. The three biggest drugmakers combined constitute only half the size of Johnson & Johnson (JNJ), Adams explained. The largest retailer in Japan is only 10% of the size of the biggest U.S. retailer.

Much harder to evaluate, though, is exactly when Japanese consumers will shift from worrying about rising prices and to actually spending.

Rowley is a correspondent in BusinessWeek's Tokyo bureau. Hall is BusinessWeek's technology correspondent in Tokyo .

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