Macroeconomics Portfolio

By Sina Frenzel

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July 8, 2016 7:00 pm JST
Drop in unemployment key to BOJ
inflation target
MOYURU BABA, Nikkei staff writer
TOKYO -- Citing past correlations, some officials at the Bank of Japan
believe a further drop in the jobless rate may be necessary before its 2%
inflation target can be achieved, which could potentially be an additional
factor pressuring the central bank toward further monetary easing.
Prices have not risen the way the central bank had hoped for, even
though the labor market remains relatively tight, with the latest May
unemployment rate unchanged from the previous month at 3.2%.
At a press conference Wednesday, Deputy Chief Cabinet Secretary
Hiroshige Seko said, "We think fundamentals of the Japanese economy
are solid, including the tight job market," despite a recently volatile
financial market. However, he refrained from making any specific
comments on foreign exchange, the stock market and long-term interest
rates, which recently renewed a historic low.
Seko also mentioned improved labor market indicators, including
the latest job-to-applicant ratio, which rose to its highest level in about 24
years.
But May's core consumer price index, excluding volatile prices of fresh
foods, dropped 0.4% from the same month a year ago, accelerating the
pace of the fall from the previous month, even though the unemployment
rate remained unchanged from April.
The unemployment rate fell below 4% in the summer of 2013 and has
since been on a relatively steady decline, albeit at a gradual pace. By
contrast, the latest core CPI inflation figure lies in negative territory.
Falling oil prices are often blamed for slow inflation, but some monetary
policy executives feel they need to see a more meaningful fall in the
unemployment rate before we see inflation accelerate any further.
"I would think inflation will not gain in momentum unless the
unemployment rate falls below 3%," a BOJ official commented.
In support of his view, the official pointed to the relationship between
unemployment and inflation between 1980 and the mid-1990s.
The unemployment rate remained below 3% for most of the period, while
core CPI inflation climbed above the BOJ's current target of 2% in the
first half of the 1980s and between 1989 and 1992 -- the second half of
the economic bubble.

However, since 1995, core CPI inflation has remained below 2% most of
the time while unemployment has risen and remained above 3%.
The labor market in the 1980s was tight as businesses maintained a
strong appetite for new hires, but as soon as the bubble burst, companies
began cutting the payroll, reducing the number of higher paid permanent
employees and increasing the amount of temporary staff.
This made for a difficult environment for wages to rise, leading to a
deflationary economy where prices fell as consumers tightened their
belts.
Although deflationary pressure somewhat weakened recently and
employment numbers have been on the rise, a BOJ official points out that
the growth is concentrated in low-wage jobs in industries such as
healthcare. The trend has been particularly prominent this year.
"Welfare is one of the industries that typically pays low wages," said the
official. "You can't expect wages to rise and inflation to accelerate unless
the unemployment rate falls below 3% and the job market tightens
further."
But for the current fiscal year through March 2017, few private sector
economists expect unemployment to fall below 3%.
Scant hope for a further drop in the unemployment rate could prove one
more factor in influencing the central bank's decision on easing in the
hope of achieving its 2% inflation target, particularly if the correlation
seen between unemployment and CPI inflation becomes a key focus.
Portfolio:

This article highlights the aim of the BoJ wanting to drop the unemployment rate in

order to reach the target of a 2% inflation. There is an inverse relationship between

inflation and unemployment. Low inflation tends to happen when Aggregate Demand

is low, however, this causes less pending and so demand for labour falls.

As one can see above on the diagram with the Phillips curve, the conflict between

inflation and unemployment states that there can only either be a high unemployment

rate (5%) with a low inflation (2%) at point A or a low unemployment rate (3%) with a

high inflation (7%) shown at point B.

The unemployment rate of Japan has often been under 3% until 1994, while the

inflation rate has been over 2% and therefore above the target. However, after 1994,

the inflation rate fell below the 2% i.e.. disinflation, which causes deflationary affects
in the economy of Japan. This deflation however, is not a benign deflation. Due to the

credit crunch it can also be seen as a malevolent deflation, meaning a deflation

where aggregate demand decreases even more and the consumers or businesses

lose confidence to invest, causing a negative multiplier effect. Other consequences

are losses of domestic and foreign investments and decline of the stock market.

Therefore, there will be a depressed job market, as prices will decrease and

unemployment will increase. A deflation in general can be determined as a sustained

period of the fall in average prices.

This diagram shows, inflation decreases from P1 to P2, causing deflation. Aggregate

demand (AD) shifts from AD1 to AD2 and therefore real output (RO) of the economy

moves from RO1 to RO2 increasing the level of unemployment. As inflation

decreases, Japanese goods become more price competitive, leading to more

exports. However, low levels of investment mean that productivity growth is low, so,

Japanese production costs remain high. Hence, the Balance of Payment (BOP)

worsens and economic growth will slow down.

This is a big problem for the economy as the government wishes to remove the

deflation and create inflation which is kept stable and low.

This can be done with two different ways of monetary easing. One way could be

cutting the interest rates and the other possibility would be quantitative easing.

When cutting interest rates in order to create an inflation, normally unemployment

rate will decrease. This method reduces the costs of borrowing, which attracts people

to borrow more, and to therefore spend more money. Aggregate demand will

therefore rise and more jobs will be created which will decrease the jobless rate. All

this will boost economic growth and inflation will occur. However for the BOJ, this

might not be a very helpful method because the interest rates have “recently

renewed a new historic low“ and they therefore have no wiggle room to cut further.

This tells us that the interest rates have been extremely low before anyway, so

cutting interest rates in this case might not be very helpful. However, low rates may

not boost spending if households pay down debt and reduce overall borrowing.

Furthermore, deflation creates a cycle of low confidence and low investment so

Consumption and Investment tend not to rise to stimulate AD growth.

To solve the problem of Japanese recession, quantitative easing can have certain

advantages in order to stop the deflation. It is the purchase from the government of

previously issued bonds which increases the flows of money, increases banking

liquidity and therefore increases consumption and investment in order to increase

aggregate demand and to therefore cause inflationary pressure. This could have the

same effect as decreasing interest rates but with a different tactic. It may also shift

the aggregate demand outwards and therefore cause price level to go up.

However, this could have some negative points as well. As borrowers and banks are

reluctant to borrow, this might cause banks to suffer from liquidity problems.

Another evaluative point could be using expansionary fiscal policy.

central bank is aiming to boost the money supply while decreasing interest rates and

to stimulate the economic activity in order to lower the unemployment rate. Interest

rates will make it cheaper for people to borrow money from banks, therefore

spendings will increase and more jobs will be created.