No. 27 — July 14, 2000


Weekly Review

--- by Douglas Ostrom

Pity the plight of the Economic Planning Agency officials assigned to write the annual report on consumer prices that the organization released in early July. How should last year's drop in retail prices be explained? Conventional wisdom would attribute what was just the second fall ever in Japan's present-day consumer price index on either a calendar or a fiscal-year basis to structural reform and increased competition as regulatory barriers eroded. However, the EPA analysis indicated that these effects were minor. Another obvious explanation is the run-up in the yen's value, which manifests itself in two ways: in falling prices as expressed in yen and in higher prices when converted into dollar equivalents.

Far from celebrating Japan's deflation as these arguments tend to do, some foreign analysts have blamed the price drop for any number of ills, including the economy's continued stagnation. Yet this line of reasoning suggests that the Bank of Japan has mismanaged monetary policy. It also undercuts the rationale for higher interest rates. The EPA report's authors emphasized structural reform and currency changes to the exclusion of monetary policy. Foreign readers, especially, are likely to be confused.

The puzzle does not arise from disagreements over the statistics themselves. According to Management and Coordination Agency data cited in the report, the consumer price index dropped 0.48 percent in the fiscal year that ended March 31. Independent analysts would argue that, if anything, the falloff was even steeper, primarily because MCA has been slow to adjust its survey to reflect shifting economic patterns — for example, the retail sector's trend toward larger stores with their lower prices. The report's compilers appear to believe, however, that the stated price decline exaggerates the deflationary forces in Japan. They note that absent a sharp drop in the prices of fresh foods, the FY 1999 decrease would have been only 0.1 percent.

This qualification notwithstanding, the main thrust of the EPA report is that the "myth of high prices in Japan" is fading. However, the agency's own numbers undermine this conclusion despite the fact that in 1999, most other industrial countries, the United States included, continued to experience rising prices, albeit relatively modest by historical standards, in contrast with Japan, where the CPI dipped 0.3 percent. By EPA's calculations, the differential rate of inflation alone trimmed 3 percentage points from the price gap between New York and Tokyo. However, the report said that prices still were 20 percent higher in Tokyo than in New York last year, adding that some basic items like spaghetti were twice as expensive in the Japanese capital.

Most surprising given the assertion that Japan's high prices are becoming a thing of the past, the gap between retail prices in Tokyo and in many other cities in industrial nations widened last year. According to EPA, New York, for example, had been only 8 percent more expensive than Tokyo in 1998. London and Geneva, which the agency said were more costly than Tokyo that year, both were cheaper in 1999. The explanation, of course, was the yen's appreciation against the dollar as well as the euro. Prices in Tokyo, which were lower in yen terms than in 1998, rose significantly when stated in these currencies.

From a foreign visitor's point of view, or that of a Japanese traveler overseas, the so-called myth of high prices in Japan was anything but in 1999. In fact, high prices there are becoming more of a reality all the time. The yen's June 30 close in New York of ¥106.02=$1.00 — against the ¥113.9=$1.00 used in EPA's calculations for 1999 — suggests that the margin has grown this year.

Despite evidence that the retail price difference between Japan and other nations is widening, EPA analysts contributing to the annual price report explained in some detail why they believe the gap is closing. Heading the list ironically is the reason that the gap is expanding: the yen's appreciation. Without the rise in the Japanese currency, prices in yen would have been 0.28 percent higher in FY 1999. Less expensive imports apparently averted this outcome. Exchange rate fluctuations dominated the other two factors identified in the report. Falling prices of deregulated goods accounted for only 0.04 point of the 0.48 percent decline, while changes in the distribution system were responsible for 0.16 point.

In other words, EPA's calculations suggest that structural shifts were overwhelmed by changes in the value of the yen, making the latter development the prime factor influencing consumer prices, even though all the talk in Japan now is about the rapid pace of restructuring. This implicit conclusion is doubly surprising given the potential for deregulation and restructuring to impact all consumer prices directly. By contrast, currency changes affect only the relatively small proportion of goods and services that are either exported or imported.

Some American analysts have taken another tack, suggesting that EPA is confusing cause and effect. In the agency's view, the strong yen simultaneously is causing ever-higher prices by international standards and lower ones in terms of Japan's currency. BOJ and its role in managing the money supply are left out of this analysis. It could be argued, however, that Japan's monetary policy has been quite restrictive, even though nominal interest rates are virtually zero. Under this alternative explanation, real interest rates are high due to dropping prices. At the same time, the yen has risen because real interest rates are steep and the demand for imports is weak. The latter, in turn, is fed by the expectation that retail prices will continue to decline. In other words, the yen's strength is the result, not the cause, of lower domestic prices. Of course, falling prices could make consumers reluctant to buy domestic as well as foreign goods and services.

This analysis casts the current debate over BOJ's zero interest-rate policy in a different light. Economists who believe as John Makin of the Washington, D.C.-based American Enterprise Institute does that real rates already are high tend to be horrified that the central bank might be planning to lift them further. As he notes in the July AEI newsletter, "[i]t appears the bank is preparing to begin raising rates to tighten monetary policy even though the country desperately needs an easier monetary policy and a goal of at least stabilizing falling prices."

Mr. Makin, in short, thinks that the deflation occurring in Japan is a sign of trouble. Even EPA's own data show that falling consumer prices are not the result of structural reform, a widely sought goal. The drop in the CPI may reflect the yen's strength or be a cause of it. In any event, EPA's numbers, if not its rhetoric, suggest that Japan's high prices are anything but a myth.

The views expressed in this report are those of the author
and do not necessarily represent those of the Japan Economic Institute

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