Will Inflation Save Japan's Economy from the Lost Decades?
Japan has gone through a long period of economic stagnation and deflation since the 1990s, frequently referred to as the lost decades, but there seems to be signs that Japan might finally be recovering. Inflation is back, and foreign investors are pouring money into the Japanese stock market.
Is Japan making a comeback from the Lost Decades? We talked to Masazumi Wakatabe, former duty governor of the Bank of Japan, and Bruce Liegel, a long time macro fund manager and author of Global Macro Playbook, for their insights on this. The transcript below has been abridged and edited for improved clarity. For the full version of the interview, please refer to our video podcast.
Hedder: Paul Krugman argued that the Lost Decades was an example of a liquidity trap, and Richard Koo of Nomura, argued that it was a balance sheet recession. What is your take on this?
Wakatabe: In my view, it has something to do with macroeconomic failures. It began with the 1985 Plaza Accord in which Japanese authorities tried to appreciate the Japanese Yen. Then the monetary policymakers engaged in a massive monetary easing, leading to an asset bubble. Eventually, the bubble burst.
So we had a number of macroeconomic failures in the initial phase. It is only after this initial phase that we saw an increase in non-perform loans and went through a balance sheet recession and liquidity trap. The Japanese policymakers were slow to tackle these problems.
Hedder: Do you see Japan finally getting out of the Lost Decades?
Wakatabe: We are now at the critical stage where we can go either way. I'm not predicting a return to deflation, but there is a chance that Japan cannot reach the 2% inflation target. Overall, if we have the right policy, I think Japan has more than a fair chance of getting out of deflation.
Hedder: There is a raging bull market in the Japanese stock market. Why is this happening now?
Liegel: We are starting to see some good economic data from Japan, and the Yen is really depreciating. The Yen is highly correlated with Nikkei and is the main driver here.
The Japanese economy is starting to accelerate. GDP was revised down to 4.8 earlier, but that is still strong. Japanese wages continue to be very low relative to the rest of the world. By that I mean their wage pressure isn't anywhere near as dramatic as Western Europe or the US, and that's keeping Japan’s inflation subdued. While inflation is trending higher, it's still relatively much lower than the rest of the world, and we never saw the peak.
Japan has a good story going on. CLSA just put out a research showing that pre-tax profit margins now are running over 9%. This trend's been going for a while, so it's nothing new. But even when you look at price to book value for Topix stocks, 50% of them are still trading below book to value. I think there are many opportunities there.
Hedder: Japanese government bond yields are still trading at a low level. How do you see the yields playing out in the long term?
Liegel: As interest rates normalize, I think it will give the Bank of Japan more latitude to slowly unwind the yield curve control program. That will bring higher rates to Japan. We are getting back to a normal market environment, which really we haven't seen for a long time on the interest rate side.
Hedder: Bloomberg reported that the Bank of Japan is purchasing Japanese government bonds (JGBs) at a record pace this year.They have been the largest holder of government bonds for some time now, accounting for more than 50% of the bonds outstanding. Is this problematic from a policy standpoint?
Wakatabe: For the short term, the purchase of the JGBs is not a problem at all. For the medium to the longer term, it will only be a problem if you worry about the sustainability of Japanese government debt.
My view is that inflation will erode away the real burden of government debt. The Japanese economy has also generated the highest ever tax revenue recently. In that sense, the fiscal situation has actually been improving.
Hedder: How do investors look at this situation?
Liegel: What I've learned after trading JGBs for over 20 years is that you don't fight the Bank of Japan. You never win. But I would say this, there are opportunities for rates to grind higher. Interest rates are normalizing, and monetary policy is becoming more prominent. Opportunities are going to present themselves with the subtle shifts in monetary policy.
Hedder: What kind of macroeconomic indicators will you be monitoring going forward?
Liegel: The CPI is still the main driver. The big takeaway is watching energy prices here. I am expecting a spike in emerging prices, and that's going to keep a floor in CPI and PPI for the next three to four months.
Wakatabe: I would add the unemployment rate to the list. Unemployment rate hasn't yet gone down to the pre pandemic level, and that really matters to the people of Japan. As Bruce mentioned, what is happening right now is the return of the nominal variables in Japan. The nominal wage growth and CPI inflation rate are now up, first in 30 years or so. We are hoping that this will end Japan's stagnation, but you have to keep in mind that they may be short lived. That's why the government and the Bank of Japan should be closely monitoring the economic situation.
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