How labour shortages may save the day for the BoJ

The Rice Riots of 1918 were a traumatic episode in Japanese history, leading to strikes, looting and the bombing of police stations. Ultimately, they brought down the government of the day.

Japan’s people are older, richer and more pacific these days, but rice is still the staple food, so a doubling of prices over the past year has led to widespread unhappiness and discussion of this century-old history.

In particular, it has fuelled discontent with the Bank of Japan, which is in the process of slowly normalising monetary policy after years of deflation and ultra-low interest rates.

Under governor Kazuo Ueda, the central bank has tightened policy for the first time in more than a decade. Rates now stand at 0.5 per cent, the highest since 2008.

But if the return of inflation is a sign of monetary policy success, the public is inclined to think that failure might have been better.

The BoJ’s problem is that modest success in achieving its goal — a self-sustaining cycle of rising wages and prices, intended to stabilise inflation at 2 per cent — has coincided with a series of one-off shocks that have driven prices well above that target.

“Looking back, starting from 2021, we observed global commodity price hikes, including in the prices of crude oil and wheat, followed by the yen’s depreciation, both of which pushed import prices upward,” said deputy governor Ryozo Himino in a recent speech.

Himino argued that inflation was not systemic or structural. “Over this period, we have witnessed a pattern in which temporary inflationary factors are successively replaced by new ones.”

Assuming this conclusion is correct, and today’s inflation is indeed temporary, the result is a difficult communications challenge for the central bank. Its view is that the domestic economy is still fragile, with inflation, excluding volatile food and energy prices, running at the much lower level of 1.6 per cent — and with the impact of US President Donald Trump’s tariffs on the way.

Such fragility argues for caution and patience on further hikes in interest rates. Yet it leaves the BoJ at risk of seeming passive and uncaring in the face of soaring food prices.

More broadly, economists welcome the return of wage rises and positive interest rates, which create a better environment for productivity growth.

The crucial factor now for the BoJ is wages. In any economy, the largest cost for companies and the main source of income for consumer spending is the wage bill. Sustained inflation over the long run will therefore require steady growth in pay to workers.

Japan’s largest labour unions secured a 5.25 per cent increase in wages this year — their highest pay deal in 34 years. But actual cash payments to workers have struggled to keep up with inflation, resulting in falling real incomes.

The BoJ’s hope is that labour shortages, which are increasing in severity because of the ageing population, will fuel ongoing pay growth, while the one-off shocks to food prices will fade out over the next year or so.

Trump’s tariffs are a threat to that scenario. Japan’s carmakers, already dealing with the rise of low-cost competition from countries such as China, rely heavily on exports to the US and they must now pay a 15 per cent tariff.

If Japanese carmakers pass on the tariff cost to US consumers, they may sell fewer cars. If they do not, their margins will fall. Either way, their profits will come under pressure, and they will have less money to fund wage rises for their workers in Japan.

In his speech, Himino identified three other channels by which US tariffs may hit Japan: uncertainty about the tariffs hurting investment; potential impacts via financial markets; and the possibility of a broader slowdown in the world economy.

“Our baseline scenario assumes that the effects of trade policies will eventually materialise, leading to a slowdown in overseas economies and a decline in domestic corporate profits. In this situation . . . Japan’s economic growth is likely to moderate,” he said.

For the Bank of Japan, then, it is two steps forward and one step back. After more than three decades, it does appear that deflation has finally been defeated. Yet the central bank needs more progress on wages to feel comfortable.

Ueda projected a positive message about the final return of inflation at August’s meeting of central bankers in Jackson Hole. “Barring a major negative demand shock, the labour market is expected to remain tight and continue to exert upward pressure on wages.”