Japan economic outlook, July 2024

Consumers poised for a rebound

Most indicators of consumer spending remain weak, but there is evidence of a turnaround. Real household spending in May was down 1.8% from a year earlier, but this is a considerable improvement from the 6.3% year-over-year decline in January.² In May, retail sales growth accelerated. But other measures of consumer spending, such as the real consumer activity index, have yet to show signs of acceleration.³ Nevertheless, consumer fundamentals have clearly changed for the better, which should usher in stronger consumer spending in the coming months.

Part of the improvement comes from the labor market. In establishments with five or more employees, scheduled earnings—a measure of wages that excludes overtime and bonuses—rose 4.7% from a year earlier in May,⁴ the fastest pace of wage growth since 1992 (figure 1). And with wage growth outpacing inflation, which stood at just 2.8% in May, compared to a year earlier,⁵ households have greater purchasing power. Meanwhile, unemployment has remained very low, at 2.6% in May,⁶ and total employment continues to grow.⁷

Meanwhile, rising food and energy prices pose one challenge to consumers. Fuel, light, and water charges were up 6.6% from a year ago in May, reversing a trend of annual declines since February 2023. Food prices were up 4.1% from a year ago and grew at an annualized 5.3% over the prior three months.⁸ The recent rebound in these prices has likely weighed on consumer sentiment and discretionary spending: The consumer confidence index fell 3.3 points over the prior two months,⁹ and real household spending on culture and recreation declined 9.6% from a year ago.

A weakening yen is partly responsible for the rise in food and energy prices. For example, the import price index in yen terms was 6.9% higher than a year ago in May.¹⁰ The yen has also continued to weaken despite market participants expecting the Bank of Japan (BoJ) to tighten monetary policy, which typically results in an appreciation of the yen. On June 27, 2024, the yen briefly hit 160.82 against the US dollar, its weakest level since 1986,¹¹ raising expectations that the government might step in to defend the currency against further depreciation.

The yen continues to tumble

If the government intervenes, its efforts are unlikely to have a lasting shielding effect on the yen. Still, the intervention could buy policymakers some time to enable conditions necessary for the appreciation of the yen to materialize. In the United States, the Federal Reserve is expected to begin cutting rates this year, which will likely lower the spread between US dollar–denominated bonds and yen-denominated ones, thereby weakening the US dollar and strengthening the yen.

At the same time, Japan’s central bank is expected to tighten monetary policy further, though the extent of tightening remains highly uncertain. The BoJ has said it will start reducing its bond purchases¹²—which would tighten monetary conditions—after hearing from market participants. In its June summary of opinions, the BoJ signaled that it would raise rates soon even if inflation has not rebounded.¹³

Part of the confusion around Japanese monetary policy is the fact that underlying inflation looks benign in the country. For example, western core inflation, excluding food and energy, was just 1.6% on a year-ago basis in May and was flat month on month since (figure 2).¹⁴

Notably, services inflation was just 1.5% in May, compared to a year ago, down from its cyclical peak of 2.3% in November.¹⁵ Such conditions would normally signal the central bank to ease monetary policy rather than tighten it.

The BoJ may tighten policy largely because the labor market is now strong enough to create more inflationary conditions: For example, wage growth is running around 4% a year, while productivity growth in the services sector has been negative for three of the last four years. This suggests that most of that wage growth will be passed on to consumers in the form of higher prices for services. The BoJ is also feeling the pressure to tighten since a weaker yen adds to the risk of higher inflation as it causes import prices to rise.

Exports grind higher

The silver lining of a weak yen is that it has driven demand for Japanese goods and services. The number of foreign visitors reached a record high in March and was 60.1% higher in May compared to a year earlier.¹⁶ This comes despite the fact that the number of visitors from China was still firmly below where it had been before the pandemic. Foreign tourism has helped boost related employment. For example, employment in accommodation, eating, and drinking services was up 3.4% from a year earlier in May, making it one of the strongest industries in terms of employment growth.¹⁷

Foreign demand is not limited to tourist services either. Goods exports have accelerated and were up 11.9% from a year earlier in May.¹⁸ A weak yen is part of the reason exports are growing so quickly, but so is the global competition for technology. Tellingly, integrated circuits exports were up 32.2% from a year ago in May.¹⁹ Transportation equipment and chemicals also grew by double-digit rates. Such strong demand for Japanese goods and services can also increase inflation as capacity constraints are tested.

Although an inflation rebound is yet to materialize, the signs of it remain too strong for the BoJ to ignore. Wage growth, in particular, is signaling that inflation will potentially move higher and that consumer spending will likely pick up soon. As the BoJ begins to tighten, the yen should stabilize or even appreciate, which will reduce the cost of food and energy, giving consumers an additional boost to their spending power. While a stronger yen may ultimately hurt Japanese goods and services exports, the yen is expected to remain weak by historical standards, which should allow ample foreign demand to persist.