The unknown mechanism of inflation  Hideo Kumano (Chief Economist, Dai-ichi Life Economic Research Institute)|電経新聞

The unknown mechanism of inflation  Hideo Kumano (Chief Economist, Dai-ichi Life Economic Research Institute)

The Japanese economy has been experiencing inflation since around 2021. Since this is a type of inflation that has not been experienced for a long time, its mechanism is not properly understood. Therefore, I would like to explain the mechanism in an easy-to-understand manner.

First, let’s ask a simple question. If a company repeatedly raises prices, where will the increased costs go?  For example, if the price of gasoline increases by 10%, or about 20 yen, due to a rise in crude oil prices, who will bear the cost increase? The answer is consumers = households. If consumer prices rise by 3%, a household that used to spend 4 million yen a year will actually have to pay an additional 120,000 yen.Suppose that the cause of this inflation was the rise in international crude oil prices. When the annual amount of imported crude oil increases by +10 trillion yen, if all of that increase in import costs is passed on to consumers, the purchasing power of households will decrease by -10 trillion yen.

Now, how will this hole be filled?  The most important means of recovery is a wage increase. If your annual salary increases by more than 120,000 yen, you can get back the additional 120,000 yen. This salary increase will increase non-oil costs for companies. Therefore, in addition to the increase in import costs, there will be an additional price pass-through. This will lead to an additional rise in consumer prices.

It can be seen that there are two types of inflation here. One is to pass on import costs. This cost does not stay within Japan, but flows overseas. The other factor is inflation, driven by rising wages. This will flow back into the country.

The latter inflation is further passed on to consumers, so households demand further wage increases. This cycle is accompanied by accelerating inflation. Inflation rate will rise. What many people don’t know is that when imports increase due to factors such as soaring oil prices, the trade deficit expands, leading to an outflow of yen funds overseas and pressure to sell the yen. In fact, this is exactly what happened in 2022 and 2023, causing the yen to weaken. This depreciation of the yen causes the value of the yen to fall and the prices of foreign currency imports to rise. This will spur a rise in import prices, which will lead to an increase in imports, which will widen the trade deficit, further accelerating the depreciation of the yen. This is also a problem that is currently occurring. Inflation continues to reduce the value of money and drain domestic purchasing power overseas.

The only way to change this situation is for companies to take advantage of the weaker yen to increase exports. While purchasing power flows out from within the country, exports cause purchasing power to flow in. Companies can also earn funds to raise wages through exports. However, Japan’s export competitiveness is weak, making it difficult for exports to increase in 2021 and 2022. Exports are finally starting to grow in 2013. The number of foreign visitors to Japan has also increased in 2013.

In addition to raising wages, another measure to prevent inflation is the Bank of Japan’s interest rate hike. In 2022 and 2023, interest rates increased overseas, and Japan was the only country with zero or negative interest rates. This exacerbated the trade deficit and accelerated the depreciation of the yen. If wages rise sufficiently in spring 2024, the Bank of Japan may raise interest rates then. The exchange rate will appreciate against the yen, and import inflation will stop. If domestic purchasing power is stopped from flowing overseas, funds will be diverted domestically through wage increases. This is a virtuous cycle.