Japan’s Deflation Battle: Will The LDP Waste Its Super-Majority?

As had been widely expected, Sunday’s election has returned the Liberal Democratic Party of Japan to power after a three-year absence. The landslide victory gives the LDP and its ally, the New Komeito party, a two-thirds majority in the lower house of parliament, the Diet, enough to overrule the divided upper house in most matters and give the new government a freer hand. But only time will tell whether Japan's incoming Prime Minister Shinzo Abe wins the war he has declared against deflation.

“We can expect a two-pronged assault on deflation with significant fiscal stimulus and a push for more aggressive monetary easing,” notes David Rea, Japan economist at Capital Economics. “However, this approach is unlikely to be successful if the government continues with the same policies we have seen before, whether enhanced or not.”

“A significant break is necessary with a focus on structural and regulatory reform. The new government should take their super-majority as a mandate to do this,” Rea added.

The LDP won 294 seats in the 480-member lower house. New Komeito won 31 seats. The overwhelming victory gives the two a “super-majority” that would allow them to force through legislation if it is rejected by the upper house of parliament, where no party has a majority. Turnout was a post-war low of just above 59 percent, according to media estimates.

Abe has vowed to end the era of falling prices and slumping demand in Japan, which is in its fourth recession since 2000, through “unlimited” monetary easing by the Bank of Japan. The argument is that that will create inflation expectations, which will translate into consumption and, in turn, greater economic growth.

Classical economics would argue that consumers should welcome deflation, since it is defined as “a sustained decline in the average level of prices.” There is “good” deflation, when innovation and rapid productivity growth helped reduce prices. But there is also “bad” deflation.

“Prices” are normally understood to include “wages,” so whatever gains one gets from lower prices are likely to be offset by lower wages.

In Japan’s case, data show that purchasing power has actually been falling faster than prices. Average earnings in Japan have fallen 12.2 percent since the 1997 fiscal year, while a core measure of consumer prices -- excluding food and energy -- has fallen 6.8 percent.

In the last 20 years, the yen has risen close to 50 percent against the dollar. But the prospect of more easing from the nation’s central bank saw the Japanese yen dropping to a 20-month low of ¥84.48 to the dollar on Monday. Also in response to Sunday’s election results, Japan’s Nikkei 225 rose 0.9 percent to its best level since April 3.

Ahead of Sunday’s poll Abe had criticized the Bank of Japan for not being more aggressive in its monetary policy. And speaking on Monday, he said the central bank should consider the election result when it meets on Wednesday to discuss policy.

“It is very unusual for monetary policy to be a focus of attention in an election. But there was strong public support for our calls to beat deflation,” Abe said at his first post-election news conference. “I hope the Bank of Japan takes that into account.”

The Bank of Japan is widely expected to take further steps to boost liquidity. “We expect the BoJ to ease further at its Dec. 19-20 policy meeting by expanding its asset purchase program by ¥10 trillion,” said Masayuki Kichikawa, Tokyo-based chief economist at Bank of America Merrill Lynch, in a note. “High economic and political risks make it likely that the BoJ will ease further in such a very short time frame.”

The Bank of Japan has so far eased policy four times this year by expanding its asset-buying program, which currently stands at ¥91 trillion ($1.1 trillion), but these measures have been ineffective in boosting the economy struggling with recession, reversing deflation and weakening the yen.

However, a note of caution remained among analysts on whether Abe can deliver on his promises.

Since the election, Abe has said he wants a policy accord with the Bank of Japan which would commit it to stronger action until an inflation rate of 2 percent is achieved. “In practice, the central bank is already committed to continued monetary easing until 1 percent inflation is in sight, and we are skeptical that further easing will make much difference,” Rea said.

“The Bank of Japan has tried to shift attention back to the government as the country cannot exit deflation through monetary policy alone,” Rea said. “The government must play its part in structural reform and deregulation, issues where LDP policy proposals have lacked detail and, arguably, ambition.”

One area of concern Rea pointed out is the proposed increase in the consumption tax in April 2014. The incoming government could delay the increase if it thinks economic conditions are unfavorable, which would could cause rating agency downgrades and reduce investor confidence in the government’s willingness and ability to put public finances on a sustainable path.

The LDP has said it will decide based on the performance of the economy in the second quarter of 2013. “This is hardly reassuring as one quarter doesn’t tell the full picture, but growth may have returned by then if Abe’s stimulus is passed early in the new year,” Rea said.

Fitch Ratings warned Tuesday that “delaying fiscal consolidation would weigh on Japan's 'A+' rating.

“We would view a delay or cancellation of the agreed doubling of consumption tax to 10 percent from 5 percent without a replacement measure as negative, but it is not clear that this will be government policy,” the agency said. “Even with the consumption tax hike, Japan faces a huge fiscal challenge compared with other major advanced economies.”

According to Fitch’s projections, Japan’s general government debt will reach 235 percent of gross domestic product at the end of this year.

A special Diet session will probably start on Dec. 26 and will last for 3 days. Abe is most likely to be elected prime minister. Once officially appointed, the new prime minister will start to form a new Cabinet.

The immediate action to be taken by the new government is to compile a supplementary budget for FY2012. It is most likely that the LDP will introduce a project to increase public works in order to stimulate the economy. In addition, the new government will need to start as soon as possible on the FY2013 budget as well.

The LDP has already shown intention for as much as a ¥10 trillion yen urgent economic stimulus package as part of the supplementary budget. “However, in our view, such a move is probably unrealistic, since it will require a large increase in bond issuance beyond what the market is able to absorb in the short-term,” writes Kiyoko Katahira, an analyst at Societe Generale in Tokyo, in a note. “Hence, we think it may not be delivered by the full amount.”