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Down Under Daily, 22 August 2014

The Wrong Sort Of Inflation


Hooray: Japan has some inflation. Unfortunately, closed economy these two inflations are the same:
its largely the wrong sort: income-cutting inflation someones purchase must have been another
in things Japanese buy, rather than debt-easing persons sale. But with trade things change: a
inflation in things Japanese sell. Incomes need to weaker currency lifts import prices, which are
rise, and rise soon. For corporates, however, that things consumed but not produced in an economy.
income rise needs to be matched by productivity
improvements to not squeeze margins. More accurately, what matters is the relative price
of exports to imports (the terms of trade). Japans
Its harder than you think to get inflation, as many terms of trade have been falling, so deflation has
policy makers are now discovering. Now Japan now been more pronounced in the things it produces
has some (Exhibit 1). than in the things it consumes (Exhibit 3).

Exhibit 1 Exhibit 3
Who Would Have Thought Prices Could Go Up? Nasty Deflation
JAPAN CONSUMER PRICE LEVEL JAPAN PRODUCTION AND CONSUMPTION INFLATION
106 100
TAX INCREASE
104 CPI EX FOOD &
98
ENERGY
102 96
INDEX JAN 2006 = 100

PRICE OF GOODS
Q1 2000 = 100

100 AND SERVICES


94
98 HEADLINE CPI CONSUMED IN
92 JAPAN*
96
90 PRICE OF GOODS &
94 SERVICES PRODUCED
TAX INCREASE 88 IN JAPAN
92
90 86

88 84 * GROSS NATIONAL EXPENDITURE PRICE DEFLATOR


GROSS DOMESTIC PRODUCT PRICE DEFLATOR
86 82
1987 1991 1995 1999 2003 2007 2011 2015 2000 2002 2004 2006 2008 2010 2012 2014 2016

Source: MIAC, ESRI; Minack Advisors Source: ESRI; Minack Advisors

Money printing doesnt guarantee inflation. But a Put another way, Japan has had to work harder
weak currency (Exhibit 2) and higher (indirect) produce more to maintain real spending. Real
taxes do. The UK had similar inflation in 2010 and GDP growth, while not exactly strong, has exceeded
2011 and that led to recession. real income growth since 2004 (Exhibit 4).

Exhibit 2 Exhibit 4
Yen Falls To Reflect Fundamentals Real Income Lags Real Production
JAPANESE TERMS OF TRADE AND CURRENCY JAPAN GDP AND GROSS DOMESTIC INCOME
150 150 115
TERMS OF TRADE* (LHS)
140 140 113
INDEX Q1 2000 = 100

111 REAL GDP


130 130
109
120 120
107
INDEX

110 YEN TWI (RHS) 110


TWI

105
100 100
103
90 90 REAL GROSS
101 DOMESTIC INCOME*
80 80 99
70 70 97
* EXPORT PRICES/IMPORT PRICES REAL TRADE WEIGHTED INDEX * REAL GDP ADJUSTED FOR INCOME EFFECTS OF TERMS OF TRADE CHANGES
60 60 95
1980 1984 1988 1992 1996 2000 2004 2008 2012 2016 2000 2002 2004 2006 2008 2010 2012 2014 2016

Source: BoJ, ESRI; Minack Advisors Source: ESRI; Minack Advisors

The problem is that this is the wrong sort of Current inflation exacerbates this real income
inflation. Good inflation is rising prices for the problem. Japans stronger growth over the past 18
things produced, because that boosts producers months has been driven by consumers lifting real
income (which in turn eases debt burdens). Bad spending without a commensurate pick-up in real
inflation is rising price for things consumed. In a labour income (Exhibit 5).

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Friday, 22 August 2014
Exhibit 5 sector. Non-financial corporates have swung from
How Wide Can This Gap? investing more than their profits to investing less
120
REAL LABOUR INCOME AND REAL CONSUMER SPENDING
NOMINAL DEFLATED BY CONSUMER SPENDING DEFLATOR
than their (rising) profits (Exhibit 8).

115 Exhibit 8
INDEX Q1 2000 = 100

Heres Where The Money Is


110 REAL CONSUMER
SPENDING JAPAN CORPORATE PROFITS AND INVESTMENT
15
JAPAN RECESSIONS SHADED
105
PROFITS*
13
INVESTMENT
100

% OF GDP
COMPENSIATION OF 11
LABOUR
95 9
2000 2002 2004 2006 2008 2010 2012 2014 2016

Source: ESRI; Minack Advisors 7

5
Spending may not be able to out-pace incomes for
* ORDINARY PROFITS, EXCLUDING FINANCIALS EXCLUDES SOFTWARE

much longer. Japans household saving rate is now 3


1980 1984 1988 1992 1996 2000 2004 2008 2012 20
near zero remarkably, below Americas, the Source: MoF, ESRI; Minack Advisors
benchmark for consumer spendthrifts (Exhibit 6).
This is a disinflationary switch. Corporate
Exhibit 6 investment rarely leads an economic cycle. It
Running Out Of Saving increases when corporate sales are rising. As an
18
HOUSEHOLD SAVING RATES
aside, a similar gap between profits and investment
16
JAPAN
now exists in the US, with similar consequence.
14
12
USA And, as in the US, this trend is something thats been
% OF INCOME

10 bad for the economy, but good for investors.


8 Japanese non-financial sector margins are not far
6
4
from all-time highs (Exhibit 9).
2
0 Exhibit 9
JAPAN RECESSIONS SHADED
-2 Better Margins
1980 1984 1988 1992 1996 2000 2004 2008 2012 20
NON-FINANCIAL SECTOR PROFIT MARGINS
Source: ESRI, OECD, BEA; Minack Advisors 9
WORLD EX-JAPAN
8
JAPAN
In short, labour income needs to grow. It would be 7
6
bearish if employment growth slows (Exhibit 7). 5
%

4
Exhibit 7 3

Uh-oh: Watch Employment 2


1
JAPANESE EMPLOYMENT AND REAL CONSUMER SPENDING
3 8 0
EMPLOYMENT* DASHED LINES SHOW 20 YEAR AVERAGES. US RECESSIONS SHADED
-1
2 6 1980 1985 1990 1995 2000 2005 2010 2015
REAL PCE (RHS)
4 Source: DataStream/Worldscope, NBER; Minack Advisors
1
4 QTR%

2
12M%

0 Japan most needs now is good inflation: inflation in


0
-1 domestic incomes. The inflation most helpful for
-2

-2
the economy now is wage inflation. Without that
-4
* 3M AVERAGE LEADING BY 2 QUARTERS
good inflation the expansion risks stalling if
-3 -6
1986 1990 1994 1998 2002 2006 2010 2014 consumer spending slows due to lack of income.
Source: MIAC, ESRI; Minack Advisors Higher wages, however, without productivity
offsets would put pressure on margins. If thats
The decline in Japanese household saving has been how Abenomics wins, equity investors lose.
matched by an increase in saving by the corporate

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Friday, 22 August 2014
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Friday, 22 August 2014