Japan economic outlook, May 2023

Inflation expectations also remain very strong. In February, 65.8% of households expected prices to rise 5% or more over the next year, the highest share since the data began in 2004.¹⁰ Since then, the share of households expecting inflation to top 5% has dipped to a still lofty 56.3%. Businesses also expect inflation to run hot. Their inflation outlook over the next three years was 2.3%, on average, which was also the highest on record.¹¹ Small- and medium-sized firms have also indicated that they are continuing to raise prices, which points to additional price pressure in the near term. 

Import and producer prices have improved recently, but both remain uncomfortably high on a year-ago basis. Producer prices were up 7.2%, while import prices were still 9.9% higher than a year earlier.¹² Although these prices should ease further, labor costs are likely just beginning to ramp up. One assessment of the ongoing shunto, or spring wage negotiations, shows wages should rise 3.7%.¹³ Not all businesses participate, and the wage gains announced typically outpace those seen in the economy as a whole. For example, contractual wage growth was just 1.6% higher than a year earlier in Q4 2022, despite a 2.1% gain during the shunto that year. If a similar differential between announced wage gains and actual wage growth emerges this year, Japan could still see contractual wage growth rise by more than 3%. 

A 3% rise in wages is likely inconsistent with 2% inflation. Wage growth can be offset by a rise in labor productivity. However, labor productivity in Japan has been weak. Productivity growth in services has been negative in seven of the last 10 years.¹⁴  Although productivity growth has been stronger in the manufacturing sector, it has averaged just 0.5% over the last decade. Assuming wages grow by 3% and labor productivity growth remains relatively flat, inflation will run hotter than 2%, which will likely force the BoJ to tighten policy. 

Consumer demand will add to inflation pressure

Consumer demand has been notably strong this year. Retail sales accelerated, rising 7.3% from a year earlier.¹⁵ Spending on general merchandise and motor vehicles has been growing by double digits. Strong wage growth will help support demand going into the summer. The labor market also appears relatively strong, with the unemployment rate hovering around where it was before the pandemic. Plus, the number of job openings was up more than 10% from a year earlier in February,¹⁶ which should put downward pressure on unemployment and upward pressure on wages. 

Some of the strength in consumer spending is likely still pent-up demand after pandemic-related restrictions were lifted toward the end of last year. Even so, there seems to be additional upside for spending, especially for services. For example, the number of guests at accommodation facilities in January was more than 7% lower than it was in 2019.¹⁷  Plus, the number of foreign visitors in Japan was still more than a third lower than prepandemic levels in March. As the economy continues to normalize, demand for tourism-related services, such as hotels, airfare, and eating out, should see some upward movement. This could create additional inflationary pressure in these categories. Prices for food away from home and airline fares were already 7.6% and 5.3% higher than a year earlier, respectively. 

Diverting trade from China

After the pandemic hit, Japan provided incentives for businesses to diversify their supply chains away from China. It appears that some movement away from China may be underway. Japan’s share of imports coming from China has fallen by 2.3 percentage points relative to 2019.¹⁸ Some of the loss is due to a higher price of oil, which Japan sources from other countries. For example, the share of imports coming from the Middle East grew by 0.9 percentage point over the same period.¹⁹ This aligns with the lost share from other major trading partners, such as the US and EU, which each lost 1.1 and 1.3 percentage points, respectively.

Japan has diverted its imports from China in two key categories. The first is in clothing, where the share of imports coming from China has fallen 5.0 percentage points since 2019.²⁰ Japan’s incentives to diversify trade early in the pandemic, largely focused on medical goods, including apparel used for personal protection. Companies were encouraged to source these goods from other countries, particularly in southeast Asia. Indeed, the share of these imports coming from ASEAN countries grew 3.7 percentage points over the same period. 

The second category is in electrical machinery, where China’s import share fell 2.1 percentage points since 2019. Electrical machinery includes semiconductors and related products. The imports of these critical goods now appear to be coming from Taiwan in increasing numbers. 

To be clear, Japan still imports more than 20% of goods from China, which is its largest single source of goods imports. It is still a bit early to determine if these changes are the beginning of a larger trend. The pandemic and the supply chain policies Japan implemented are likely having some effect. Geopolitical tensions between China and the West will likely drive additional diversification in supply chains moving forward. If these trends continue, the costs of moving supply chains could be passed on to consumers, which would add to the inflationary pressures seen in the economy. 

Japan’s economy is expected to grow modestly as pent-up demand drives spending in the near term, and a relatively strong labor market maintains spending thereafter. The path of inflation will largely determine changes in monetary policy and therefore how quickly the economy can grow this year. The BoJ is likely to take a relatively dovish approach, only tightening modestly this year, as it expects some of the inflationary pressure to recede by year-end. Although this is supportive of growth in the near term, it could lead to higher inflation and a more hawkish response from the BoJ.