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A Review Focusing on the 1990s
October 6, 2000
Bank of Japan
Research and Statistics Department
Click on ron0010a.pdf (733KB) to download the full text.
1. In the mid-to-long-term perspective, during the 1960s, Japan's economy experienced moderate inflation. Domestic wholesale prices rose by about 1 percent on average (year-to-year), while consumer prices increased faster by around 5 percent on average. In the 1970s, Japan experienced high inflation, triggered by excess liquidity and the first oil shock. Domestic wholesale prices and consumer prices both rose by more than 20 percent. The 1980s and 90s were periods of disinflation. During those years, inflation rates in domestic wholesale prices basically continued to be negative, and those in consumer prices remained in a small range of slightly more than 3 percent to a slightly negative level.
Close examination of the price developments during these 20 years shows that in the first half of the 1980s, inflation rates decelerated at a relatively rapid pace. During the asset bubble period in the second half of the 1980s, inflation rates were relatively stable, even when economic growth accelerated and asset prices skyrocketed. However, through the beginning of the 1990s, when the asset bubble was about to end, Japan's economy was under inflationary pressure and inflation rates began to increase gradually. Thereafter, they decelerated again and in the latter half of the 1990s, the economy sometimes suffered from deflationary pressure.
2. Factors that determine price developments discussed above are summarized as follows.
First, long-term trends in price movements from decade to decade depend largely on expected rates of inflation. Developments in expected rates of inflation are influenced by the Bank of Japan's reputation in regard to policy stance for price-stabilization. Furthermore, developments in money stock seem to have affected price levels in the long run.
Second, cyclical behavior of prices depends basically on strength in demand against domestic capacity for supply (the output gap) and on production costs, such as import prices.
Third, developments in productivity also affect long-run movements in prices. Productivity growth of the macro-economy influences overall trends in prices. A difference in productivity growth between manufacturing and nonmanufacturing industries means that inflation rates of domestic wholesale prices tend to be lower than those of consumer prices.
3. The price movements in Japan during the 1990s were determined basically by developments in the output gap and were affected by fluctuations in exchange rates and crude oil prices. At the same time, however, recent price developments have also presented the following puzzles.
4. Although Japan's economy was once on the brink of a deflationary spiral in 1998, prices did not fall as sharply as predicted by the output gap for the following reasons.
First, Japan's potential growth has slowed in the mid-to-long-term perspective and capacity growth is also limited in the short-term perspective, as existing capital stock became obsolete amid economic globalization and progress in IT (information technology) since the second half of the 1990s. Consequently, the true output gap may have been smaller than expected from the potential growth usually imagined. Second, while firms undertook corporate restructuring, the labor skills required by firms changed, which increased the mismatch between demand and supply in the labor market. This in turn seemed to have lowered the equilibrium level of the output gap. In addition, facing unprecedented deterioration of the economy, firms became pessimistic about an expansion of the market in the future and tried to avoid immediate price cuts as much as possible to maintain short-term rates of profits.
5. The instability of the relationship between money stock and nominal GDP increased from autumn 1997 to the beginning of 1999, because liquidity preference strengthened sharply due to financial anxieties over the stability of the financial system that surged from autumn 1997. If this situation had been prolonged, firms would have provided the market with stocked commodities to gain liquidity, which would have likely led to further deflation. However, the Bank of Japan and government introduced financial measures in autumn 1998 mainly to avoid a further credit crunch. Furthermore, the Bank adopted the "zero interest rate policy" and the government injected public funds into private banks in 1999. These measures were effective to prevent the economy from falling into a deflationary spiral.
6. For the analysis of the price trends during the 1990s, it is indispensable to evaluate the effects of technological innovation and streamlining of distribution channels.
Technological innovation continued to exert downward pressure on prices throughout the 1990s by pulling down prices of electronic machinery and related goods. Further price cuts will occur, when more industries introduce new technology, thereby increasing economic productivity. In fact, technological innovation has recently been prompting structural changes in distribution sectors.
Additionally, since the 1990s, "price-destruction" or "globalization of prices" is becoming apparent, as the gap between domestic and foreign prices has diminished with the former falling down to the latter. (i) The appreciation of the yen encouraged the industrialization of Asian economies and the enlarged domestic-foreign price gap in some commodities caused the influx of inexpensive products from these economies into Japan. (ii) Deregulation in Japan exposed some industries to market competition, which exerted downward pressure on their prices. (iii) A new style of distribution business triggered streamlining of distribution channels particularly among apparel industries, during the first half of the 1990s as well as in recent years.
There are various backgrounds of the previous phenomenon including arbitrage between domestic and foreign prices as well as introduction of new business models applicable to global businesses. Their ultimate consequence is to enhance economic efficiency. It should be kept in mind that certain industries and firms will suffer from a profit squeeze in the adjustment process however.
7. Although it is still large, the output gap is closing gradually in line with the economic recovery that started in spring 1999.
In this situation, "downward pressure on prices stemming from weak demand" seems to be declining significantly, although the consumer price index and GDP deflator remain below the previous year's level.
Needless to say, it is difficult to measure how much of the changes in price levels comes from "downward pressure on prices stemming from weak demand." Furthermore, price declines may have a negative impact on the economy in the short run, even though they do not come from weak demand, such as price declines induced by closing of the gap between domestic and foreign prices. In this situation, one way to see whether the Japanese economy is under deflationary pressure is to examine the background of price behavior from the distributive side. Currently, corporate profits are increasing without a decrease in the compensation of employees. This implies that the current Japanese economy is "in a situation where deflationary pressure reflecting the imbalance between supply and demand is almost dispelling."
8. The output gap will diminish and deflationary concern is expected to dispel in the near future. Nonetheless, because of the existence of a large output gap, prices are unlikely to rise sharply in the immediate future, unless the economy recovers at a rapid pace.
Investment to IT has started to become active in the Japanese economy. If such investment spreads throughout the economy and enhances the total productivity of the economy, it will constrain price rises. Nevertheless, there is no clear evidence that shows that IT stimulates the total productivity of the economy, except for the enhancement of productivity among IT manufacturers, especially that of the electric machinery industry. It will also take some time before the mismatch in the labor market disappears, thereby enhancing the total efficiency of the economy.
Furthermore, in distribution sectors, various efforts have started to bear fruit by improving productivity and such progress may continue further. In addition, reduction in various fees due to deregulation is also expected to continue. Attention should be paid to the possibility that in these circumstances, consumer prices may weaken further even amid economic recovery.