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Looking ahead at the Japanese economy in 2008: Part I

This is Part I in what should be a two part summary on where the Japanese economy stands heading into 2008. For those who have been following Japan Economy News, little of this will be brand new information, though we felt it would be helpful to organize things into a series. Essentially, we are gloomy on the possibility of economic growth being driven by domestic demand in 2008, and this essay is meant to show why. In this first part, we will begin considering consumer prices and inflation, take a look at how food prices factor into the picture, move on to take a look at household spending and domestic demand, return to inflation and then begin to make the move into GDP projections for 2008. Enjoy!

Consumer Prices and Inflation

In November, we saw Japan’s core consumer price index rise by 0.4 percent against the same month in 2006. This was the highest rise in prices seen since March 1998, when prices jumped up 1.8 percent. Granted, the November rise is nowhere near as high as that figure from 1998, but it was a bigger jump than most analysts expected, which we take as a good sign. Why is that a good sign? Simply put, when things don’t happen quite the way the analysts predict, it usually means that something interesting and difficult to analyze is happening.

In terms of consumer prices, it is essential for us to keep in mind that ‘core CPI’ includes energy prices in Japan. We also need to keep in mind that higher oil and other energy costs have been behind the rise in CPI seen in both October (+0.1%) and November (0.4%). When energy costs are stripped out of October’s figures, the CPI was down 0.1 percent. When energy costs are stripped out of November’s figures, that 0.4 percent rise yet again becomes a 0.1 percent fall.

Thus, continued increases in oil and energy costs will probably be necessary in order for Japan’s core CPI to continue any substantial rise in early 2008. Will oil prices continue to rise? That’s a prediction we won’t make, but we will assume that 2008 prices per barrel will stay above the 2007 level - at least for the first half of the year. This will ensure that upward pressure on the CPI remains, and may accelerate if firms (other than food makers) decide to pass on higher costs to consumers.

When we look back at 2007, core CPI struggled for most of the year, declining for each of the first nine months. In the first half of the year, oil prices were lower than they had been in 2006, and we heard a bevy of government officials and spokespeople assert that once the high oil prices from the first half of 2006 were flushed out, the core CPI would again begin to rise. This has turned out to be true, though not because non-energy prices are rising overall (yet), but because a huge surge in oil prices in the last half of 2007 when compared to lower oil prices in the latter half of 2006 has distorted core CPI readings.

What’s also important to note is that back in March, April and May, we heard talk that falling CPI should not prevent the Bank of Japan from raising interest rates - though most of this talk came from the Bank of Japan itself. Now that we have CPI on the rise, we are actually hearing less about interest rate hikes, and the Nikkei has even published speculation that they BOJ might have to cut rates in early 2008.

At the beginning of 2008, we have crude oil trading above $96 a barrel and gasoline futures at an all-time high, so if there is downward pressure on oil prices, that’s not yet being reflected in the market. In 2007, crude oil opened around $60 per barrel. With 2008 set to open at over $96 per barrel, Japanese firms are facing medium-term increased operational costs, and those costs are most likely going to need to be passed on to consumers. Some firms have begun to do so, but it seems possible that we will begin to see many more companies make the decision to raise prices in the first two quarters of 2008. We will get more into why we think this could be a dangerous situation in just a little bit.

Edit: Oil prices have just been reported to have jumped over $100 per barrel.

Food prices

Prices of fresh food are not included in Japan’s core CPI. Of course, we all know the reason for this, but in order to take a look at the economy as a whole, and especially at what might happen with consumer spending and domestic demand, we are going to have to look at inflation in food prices, as well as what happens to the CPI when fresh food is included.

We have the nationwide CPI data covering up to November 2007. When we look at it, it’s obvious that when energy and food costs are stripped out, CPI is still in negative territory, though heading towards zero. Although energy prices are driving prices upward more than food prices are at the moment, there is no doubt that food prices are on the rise.

In November, prices for nonperishable foods increased 0.3 percent and overall food prices shot up 0.9 percent, as food producers increased prices in order to offset higher production costs. We also know that further increases are on the way for both perishable and nonperishable foods. In January, instant noodle and beer prices are set to rise, while milk prices will be increasing from April, to cite but a few cases. We see little reason for there to be downward pressure on food prices at least for the first half of 2008.

In November, spending on food accounted for 65,751 yen out of an average total household spending figure of 282,836 yen. In other words, food spending represents about 23% of the average household budget.

At the end of December, we commented on the strange phenomenon of food prices having increased 0.9 percent in November while spending on food declined 0.9 percent. Food sales at supermarkets and department stores also rose, so we’re not sure if there is some glitch in the numbers. Assuming they are accurate, we seem to have a situation in which supermarkets are benefiting from higher food prices, though overall sales are declining as they continue to pare down non-essential operations such as the sales of clothing.

Household Spending

Together, food and energy spending accounts for about 30% of Japan’s average household budget. This is by no means a small figure. We assume that with prices set to rise in these two categories, households will be forced to crimp spending in other areas, especially if negative wage growth continues into 2008.

It thus seems clear that we will see higher spending on food and energy in the early months of 2008, possibly at the expense of spending in other categories. However, we are still not seeing any upward movement on wages, which means increased spending on food and energy will most likely have to be offset by spending cuts in other areas.

The most recent consumer confidence index data (for November 2007) saw a huge drop in the score for “Willingness to buy durable goods.” In the November survey, that score stood at 38.4. It had not reached such a low level since the 31.4 reading seen in March 1997.

November readings of all five consumer confidence categories were very low, and there seems to be little upside pressure on consumer sentiment. One might cite the fact that winter bonuses were at an all-time high in 2007, but we would have to counter with the fact that fewer employees are actually receiving bonuses, as contract workers now compose somewhere around 30-33% of Japan’s workforce. We also see the rate at which bonuses are increasing approaching zero. Data from the next round of bonuses coming up this summer will be interesting to watch. We do not expect to see them much higher than the winter bonuses.

At any rate, that brings us back to household spending. We know that about 55% of Japan’s GDP is driven by domestic demand. We are also pessimistic on the possibility of growth in Japan’s domestic demand, especially for the first quarter, if not the first half, of 2008. Such a situation is dangerous, because it means that any inflation we may see will be driven by higher costs rather than demand. As Claus Vistesen points out on his Alpha.Sources blog:

In other words, what we are seeing are not demand-pull inflation which would have been the hallmark sign of a recovery driven by domestic demand but rather cost-push inflation which is being imported through high energy and base commodity prices; remember all that flurry of the rising price on mayonnaise, Starbucks lattés as well as recently wholesale prices which would rear their head in the PPI indice(s).

Stefan Karlsson also makes a case that the current inflation in consumer prices is not necessarily a good sign:

Consumer prices in Japan was up 0.6% in the year to November. While that is a lot less than the 4.3% in U.S. and the 3.1% in the Euro area, that represents a significant increase and it alsos represents an end to deflation. So, according to the ignorant Financial Times journalists, this must have represented a boost to the Japanese economy. But as a matter of fact, it didn’t as it meant a reduction in purchasing power and therefore consumer spending[.]

I’m not fully convinced that the 0.1% rise in October and the 0.6% rise in November represent an end to deflation, but that might be because we’re seeing the “wrong” kind of inflation. At any rate, once energy prices are stripped out, CPI is still in negative territory, and thus I feel we still have a few months left to go before the end of deflation can be officially declared.

Thus, we’re back to consumer prices and inflation, which means it’s finally time to get into a discussion of GDP…which will happen in Part II of this summary, which should be out in just a few more days…

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