Structural features of Japan’s deflation and its CPI Basket

Abstract

This paper reviews the key factors that underpin Japan’s experience of prolonged and mild deflation since the 1990s. Developments in Japan’s population demographics, central bank communication and media sentiment have played a pivotal role in shaping inflation expectations. Fragile inflation expectations coupled with zero-bound nominal interest rate and a high exchange rate have had a detrimental impact on aggregate demand. Despite aggressive quantitative easing, Japan’s recovery from economic stagnation has been weak in the face of permanent negative demand shocks from asset bubble bursts and a flat Philips curve. Prices are sticky as firms don’t adjust prices to accommodate for economic conditions. A decomposition of the CPI basket reveals that the Bank of Japan (BoJ) cannot influence prices of a large number of products. The demand structure of an ageing economy leads to inclusion of many healthcare products in the CPI basket and these prices cannot be changed drastically. When the price developments of these products are compared against the US, we find that the US and several other countries experience a default inflation rate of 2% while Japan doesn’t. We further study the success of the Abenomics in lifting the economic morale and the looming economic dilemmas that surround Japan’s recovery programs.