Recent policy changes by the BOJ signal the potential for a sea change in pricing and wage dynamics in the country
In the short term, firms will continue to see pushback on price increases, though the process may be easier than it has been historically. Wage costs will also increase across the country, not only for employees covered by the shunto agreement or the minimum wage, but also as a result of workers using these precedents to bargain for higher pay.
In the longer term, sustainable inflation will gradually improve overall pricing conditions, as Japan exits its deflationary spiral. This would also prompt the central bank to raise short-term interest rates, marking a dramatic change to overall domestic investment dynamics and ROI calculations for firms. Moreover, as most other countries will continue to see higher rates of inflation and interest rates, Japan may become a more attractive investment destination as a relatively low-cost developed market with strong infrastructure. These trends will support both reshoring of manufacturing from domestic companies (as seen in the semiconductor industry) and friend-shoring (as companies diversify away from China).
Overview
The Bank of Japan’s (BOJ’s) recent decision to loosen its yield curve control policy (YCC) has spurred debate around whether the central bank will raise the country’s negative short-term interest rates. However, the BOJ has repeatedly stated that it will not raise short-term interest rates until inflation is sustainably above the 2% target. The YCC change represents a middle ground between a stimulatory monetary policy and restrictive one by allowing long-term interest rates to rise while keeping short-term rates negative. The move is also an early indication that the central bank is concerned that current levels of inflation may not be transitory. The four main reasons for this are:
- The need for firms to continue passing on price increases: Given heightened customer pushback to price increases, firms refrained from raising prices on goods and services in 2022. However, it has since become obvious that this strategy is not sustainable. Producer prices have risen by 17% since the beginning of 2020, while consumer prices have grown by less than 5% in this period. As this is eroding firms’ profitability, they have been raising prices gradually. This is represented in the fact that core inflation is rising as fast as headline inflation, at 3.3% in June, which signals that current levels of inflation will persist.
- Growing wages: Higher inflation over the past year has led to both unions and policymakers calling for higher wages. This year’s annual shunto saw major manufacturers agree to wage increases of 3.9%, the largest in over 30 years. Similarly, the minimum wage in Japan has been set to grow by 4.3% in 2023, the highest increase since 1991. Additionally, major Japanese firms, such as Suntory, Fast Retailing, and Nikon, have agreed to even larger wage increases and are shifting away from the lifetime employment model to a compensation system that prioritizes performance and productivity.
- Policy push from Tokyo: Labor unions’ and firms’ efforts to raise wages are also being supported by the Kishida administration, which has made wage growth one of its key economic priorities. The government hopes that a sustained increase in household wages will spur domestic consumption, supporting both economic growth and healthy levels of inflation in the economy. To that extent, Tokyo is offering various incentives such as tax benefits for firms that raise employee wages and is also increasing salaries of public sector workers.
- FX weakness: The yen’s historic weakness will also put upward pressure on domestic prices. As Japan relies heavily on imported inputs across various sectors of the economy, the higher cost of imports will translate into domestic inflation as well. Since the yen is expected to remain weak—relative to historic standards—over the medium term, this will continue to drive domestic inflation.
Our View
While Japan’s shift away from a deflationary spiral may be welcome news to multinationals, it is important to stress that these are early signs of a trend and by no means a clear indication of an environment of healthy inflation. Despite some of the trends highlighted above, Japan has not seen sustained inflation in decades and there will be inertia in the economy to move away from this. Nonetheless, conditions right now are more conducive to sustained price growth than they have been in the past decades. The evolution of inflation dynamics over the next 12 months will be crucial in determining whether sustained price growth will come to pass or if the current wave of inflation is transitory.
A virtuous cycle of sustainable inflation along with healthy wage growth would create stronger demand conditions, especially for B2C companies. The gradual move away from Japan’s deflationary mindset would also improve pricing challenges for B2B firms serving domestic-oriented companies. Finally, even if Japan does pull out of its deflationary spiral, overall levels of inflation and interest rates will remain well below rates seen in other markets. As a result, other markets with stronger inflation dynamics could surpass Japan in terms of the operation, production, and wage costs in the longer term. These trends, when combined with more favorable pricing and growth conditions as well as Japan’s status as a manufacturing hub with a stable policy environment, could lead to the market becoming more attractive as an investment and manufacturing destination in the long term.
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