BOJ won’t break

The last deflationist standing is not going to fall unless something changes. Pantheon has the note.

Japanese CPI inflation was unchanged in May, at 2.5% year-over-year, the second month above the BoJ’s 2% target. We now expect inflation to remain above target for the rest of the year, thanks to the ongoing weakness in the yen. But we still don’t expect a change from the BoJ, who have been consistent in their messaging. Inflation driven by cost shocks, and unaccompanied by wage growth, is not regarded as sustainable, and does not warrant tighter policy. Policy settings should remain on hold into 2023.

Headline inflation, core inflation, and core core inflation were all unchanged in May, the latter two at 2.1% and 0.8% year-over-year, respectively. We saw some small compositional shifts. Food inflation accelerated to 4.1% year-over-year, from 3.9%, and household durable goods inflation climbed again, to 7.5%, from 5.0%, between them offsetting a decline in energy inflation to 17.1%, from 19.1%. But most other subcomponents were as tranquil as the headlines.

We should see further declines in energy inflation from here, as suggested by our chart below. Global oil prices have fallen over the course of June, and paired with base effects and government subsidies, this should see the energy component of CPI head lower. We would see more of a decline, if not for the weakness of the yen, which offsets some of the dollar price decreases.

Global food commodity prices have also begun to cool slightly, but Japan must first navigate the increases of prior months, which take time to feed through to the CPI numbers. Yen weakness is a key consideration again. Japan is a heavy net importer of food, as with energy. Food inflation will likely head higher in the short term. But from the BoJ’s perspective, this is only transitory. Food price inflation should retreat by 2023, thanks to more favourable base effects.

The increase in durable goods inflation—and a smaller increase in other core goods inflation—should draw more attention than the increases in energy and food, which are beyond the BoJ’s ability to control. But even here, we think this inflation increase has more to do with rising input costs, with core goods tending to track PPI inflation. Further increases seem likely in the wake of recent rapid yen depreciation, as shown in our chart below. Such price increases, however, tend to be self-limiting, in that they eventually destroy demand, unlike those driven by strong income growth. Monetary policy does not need to tighten in response, particularly with inflation only just above target.

We do not see May’s inflation data as a sign that a change of monetary policy is needed. The messaging from the BoJ has been clear and consistent. The goal is not simply inflation above 2%, but to see core inflation sustainably above 2%. That means price increases accompanied by wage growth, such that demand is driving inflation, rather than cost shocks.

Domestic demand remains some distance from this goal; Governor Kuroda has warned that any tightening of policy at this point risks an economic contraction.

The other sources of pressure on the BoJ meanwhile, from currency and fixed income markets, have begun to recede. Global bond yields have fallen sharply in the last week, akin to a fever breaking, as U.S. data forced a rethink of speculation about multiple 75bp hikes by the Fed. The retreat of bond yields applied also to JGBs, with the 10-year bond retreating from the 0.25% ceiling, and relieved some pressure on the yen, which has pulled back from recent highs.

The market situtation remains volatile, however, and stronger-than-expected U.S. data could easily see the situation reverse just as quickly. But our Chief Economist, Ian Shepherdson, remains of the view that U.S. data will cool more than expected. Governor Kuroda, meanwhile, is apparently unruffled either way, insisting at the latest BoJ meeting that monetary policy should aim to stabilise prices, not currencies. We do not expect that to change.

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