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HOME NRI JOURNAL Takahide Kiuchi's View - Insight into World Economic Trends :
Will There Be a Virtuous Cycle of Wages and Prices?


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Takahide Kiuchi's View - Insight into World Economic Trends :
Will There Be a Virtuous Cycle of Wages and Prices?

Takahide Kiuchi, Executive Economist, Financial Technology Solution Division

#Market Analysis

#Takahide Kiuchi

Jan. 12, 2024

2024 is being regarded as the milestone year that will decide whether Japan can achieve a virtuous cycle of wages and prices. Against the backdrop of historic price surges, the annual spring labor-management wage negotiations in 2023 led to the highest wage growth rate seen in 30 years. It’s expected that 2024 will see wages increase even further, with that rise then being passed on to prices, leading to a cycle in which prices and wages rise synergistically.

The key is for the real wage growth rate to rise sustainably

However, I don’t think that what is meant by the phrase “virtuous cycle of wages and prices”, at least as it’s come to be used these days, is all that clear. Although the synergistic rise of wages and prices is expressed as a virtuous cycle, if both were to increase at the same pace, the real wage growth rate (meaning the nominal wage growth rate minus the inflation rate) would be unchanged. Absent any change in the real wage growth rate or in its prospects, the pace of improvement in people’s living standards and their future prospects also wouldn’t change.
What’s economically important here is the extent to which real wages do rise. Forcibly boosting the nominal wage growth rate would make it possible to temporarily raise the real wage growth rate. Yet in that case, the distribution would lean toward workers themselves, and as labor’s share of income rises, corporate earnings would be compressed. As a result, companies would move to curb hiring and wages, and the real wage growth rate—having briefly risen—would once again end up falling.
If there were no change in the distribution, the real wage growth rate would be determined by the labor productivity growth rate. Therefore, the key thing is to aim to raise the labor productivity growth rate and have the benefits evenly distributed among companies and their workers, so that the real wage growth rate will go up in a sustainable and stable fashion.

Continued steady efforts to raise economic potential are vital

To ensure that the real wage growth rate rises sustainably, the government will need to pursue growth strategies that address the nation’s falling birthrate, reform the labor market, promote inbound tourism, remedy the overconcentration of major cities, and utilize foreign labor, among other things. If those strategies bear fruit, and lead future growth prospects to improve, then companies will likely become more active in making capital investments, which will then boost the labor productivity growth rate.
Companies will be required to make continual efforts to raise their production efficiency and promote technological innovations. And individuals will have to make efforts to improve the efficiency of their operations, as well as strive to continually refine their skills through relearning (reskilling), so that they can gain new knowledge.
If the government, companies, and individuals (workers) all make such continues and steady efforts, the potential growth rate, the labor productivity rate, and other measures of economic potential will all rise, and the resulting benefits will spread to companies and households (workers). And if growth rates rise, then the government’s fiscal conditions will also improve by way of higher tax revenues.
The important thing is to improve things like the labor productivity growth rate and the potential growth rate, or what’s referred to “real values”. Improvements in the inflation rate, the wage growth rate, or other such “nominal values” will arise as a consequence of any improvements in these real values, and any attempts to directly manipulate these nominal values will probably fail to turn economic conditions around for companies or for individuals.
I think it would be problematic for the Bank of Japan to aim to raise the inflation rate or inflation expectations (inflation rate forecasts), or for the government to call on companies to raise wages, at least from the standpoint of improving real values.

Rising inflation expectations alone won’t improve real private consumption

The notion that if inflation expectations rise, the deflationary mindset will be dispelled and the economy will improve may be intuitively accepted among many people, but economically speaking it’s not necessarily correct.
if we follow the standard theory of consumption, real personal consumption expenditures at a given point in time are mainly determined by the outlook for total real income (wages) into the future and by real interest rates. I think the notion that if inflation expectations rise individuals will hasten to spend more before prices increase is incorrect in theory.
That’s because even if inflation expectations do rise, if expectations about the rate of increase of nominal wages going forward also see a corresponding rise, then the real income outlook which determines people’s buying power will not change. Plus, if nominal interest rates rise only as much as inflation expectations do, the level of real interest rates—which influence present and future spending rates—will also be unchanged.
In addition, even if rising prices lead nominal corporate earnings to increase, that likely won’t lead companies to increase their real business fixed investments. If earnings surpassing the inflation rate, which is to say real revenues, do not increase at a faster rate, then this situation likely won’t lead companies to make more capital investments, or to hire more workers.
Although 2023 did see the inflation rate and the nominal wage growth rate rise conspicuously, this was very much a temporary effect resulting from the rise in import prices. Any expectation that this would spur Japan’s growth rate to rise and improve people’s lives is, I think, lacking a strong foundation.
The important thing here is not to adopt a passive stance and simply wait for these changes to transpire, but rather for the government, companies, and individuals (workers) to make continuous, steady efforts daily to improve the country’s economic potential.

Will higher inflation expectations restore the efficacy of our monetary policy?

That said, a rise in inflation expectations has significance for the Bank of Japan’s monetary policy. That’s because if even amid rising inflation expectations there’s no change made to the level of nominal policy interest rates, real interest rates will decline, producing economic stimulus effects.
It’s also because if inflation expectations rise, then without changing the real interest rate level, the Bank of Japan will be able to raise nominal policy interest rates while maintaining a neutral monetary policy vis-à-vis economic activity.
In that case, when an economic crisis, financial crisis, or other such major shock occurs, by rapidly lowering policy interest rates, the Bank of Japan will be able to ease the pain on the economy. That is one of the major functions expected of monetary policy, and from that perspective, this means the Bank of Japan can restore to some extent the efficacy of its monetary policy.
The recent uptick in the inflation rate, medium- and long-term inflation expectations among companies and individuals seem to have risen somewhat as well. However, it’s unclear whether that’s sustainable. A rise in medium- and long-term inflation expectations while the labor productivity growth rate, the potential growth rate, and other economic real values remain unchanged could end up merely being a temporary phenomenon, and might not be possible to sustain.
If companies were to actively raise the prices of consumer goods and services while the labor productivity growth rate stay flat the and the real wage growth rate shows no improvement, it would encourage consumers to refrain from spending their money, which would make it difficult for companies to raise their prices. That would ultimately end up causing people’s medium- and long-term inflation expectations to fall again, most likely.

The Bank of Japan will likely take care in revising its policy

For the Bank of Japan to be able to revise its monetary easing policy in earnest and noticeably raise the level of its policy interest rates, economic potential will need to be higher, thereby leading the inflation rate and inflation expectations to rise sustainably. Perhaps we can conclude that the unprecedented monetary easing policy which has now lasted longer than a decade failed because it tried to forcibly create such conditions by way of monetary policy.
However, now the Bank of Japan might have strong hopes that the triad of the government, companies, and individuals (workers) will all steadily strive to raise the country’s economic potential, and thereby make it possible to restore the efficacy of its monetary policy.
The Bank of Japan can be expected to embark on policy corrections such as the elimination of negative interest rates in 2024 as well, with the aim of mitigating the side effects brought about by this extraordinary monetary easing. Yet since Japan’s economic potential shows no signs of any major improvement, there would seem to be little chance of that leading to a significant rise in interest rates.
Fully cognizant of the risk that raising policy interest rates beyond the economy’s growth potential could do economic damage, the Bank of Japan will likely be cautious about making any policy revisions going forward.

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