With Japanese wages now also growing in real terms can wage inflation also add to the impetus behind the Japanese economy. How long will this trend continue? How high will Japanese wages go – or could underlying demographic challenges shorten this recovery in wages and consumer confidence?

If wage growth does feed through into higher consumer spending sectors of the economy, which are best placed to benefit from that?

Japanese real wage likely to continue growing for next few years

The Government is now actively supporting wage growth to avoid inflation eating away at household budgets – which would reduce consumption. Government assistance to help real wages is set to continue rising – surpassing price increases – over the next few years.

2024’s minimum wage increase rate of approximately 5 per cent is far higher than the norm for that past three decades. Meanwhile, growth in the Japanese Consumer Price Index (CPI) was 2.7 per cent in the year to August 2024.

The Government has set a target to further raise the minimum wage to 1,500 yen per hour by the mid-2030s. If this target is achieved, we should expect annual wage increases exceeding 3 per cent.

Most analysts initially assumed that inflationary pressures would not spill over into domestic prices – judging that companies would be unable to raise prices for fear of losing consumers. However, Government measures subsidising consumer prices and supporting wage increases have enabled companies to pass on price increases while stimulating above-inflation wage growth.

Service prices in Japan – directly influenced by wage trends – will likely rise in the short term. Real terms durable goods consumption has already recovered to pre-pandemic levels, while services expenditure has yet to reach pre-pandemic levels.

Retail and service sectors poised to benefit most

The retail and service sectors are likely to significantly benefit if wages continue to grow. Data from the past 20 years shows a strong positive correlation between wage growth and consumer spending – suggesting rising wages will increase household expenditure.

The age groups experiencing the fastest wage growth are workers in their 20s to early 30s – and the smaller purchasing power of the 60+ bracket.

While consumers in their 20s tend to spend more on rent, eating out, culture and recreation, expenditure for those aged 60+ skews more towards groceries, healthcare, and car and tech repairs. Given that Japan’s minimum retirement age is 60, consumption trends among those in their 20s will have a greater impact on the Japanese economy.

We expect that equities in these consumer subsectors will benefit from that considerable jump in demand. Over the past three months, the TOPIX industry indices show the retail sector has outperformed with an average share price rise of +8.5 per cent. Service sector shares have risen by +6.3 per cent on average – significantly outperforming the overall TOPIX, which declined by 3.1 per cent.

Market expectations of wage growth and price inflation have been major drivers of rising Japanese share prices over the past year.

Labour shortages and a weak yen contributing to real wage growth

Japan’s major demographic challenges – chiefly an aging population and declining birthrate – will further contribute to sustained wage increases. Both factors will exacerbate labour shortages in the long term. Current labour shortages are also prompting short term investments in automation – enhancing labour productivity and further supporting wage growth.

Additionally, the yen’s weakness against the dollar has now likely peaked. Wage growth is now being supported by a stronger yen – helping ensure sustainable wage growth for Japanese workers.

However long-term economic anxiety among Japan’s youth could incentivise greater saving – hampering further growth in the economy

While wage growth now outpaces inflation, it’s still only a modest increase – just over three per cent. Japan is already burdened by an expensive welfare state and growing welfare contributions will bite into this extra disposable income.

Longer-term anxiety – particularly amongst younger people – may constrain further increases in consumer spending. Japan’s long term economic prospects remain uncertain, particularly with an ageing and declining population – and corresponding ballooning welfare costs. Many younger people see greater saving as the prudent option for the long term.

There’s a large economic incentive for the Government to keep supporting wage growth – boosting domestic consumption. We, therefore, expect this trend of real terms wage growth to continue over the medium term. However, to secure sustainable wage growth in the long term, the Government will have to consider the structural changes needed to address a declining population.

Japanese households and Government are enjoying the short-term benefits of increased economic activity. Both want to realise the benefits of the current economic uplift – wages will keep growing, at least until the 1,500 yen per hour target is hit.

The only problem is that a stronger JPY and higher interest rates directly impede the BOJ’s efforts to break for good from Japan’s decade-long disinflationary vicious cycle; price stability is, after all, the BOJ’s primary mandate.

For investors’ positioning in the Japanese markets, it is essential to understand how this ‘conflict’ between the MOF and the BOJ eventually plays out.

Yen is cheap by any measure

The Yen looks cheap based on any fundamental metrics. For example, according to the Real Effective Exchange Rate (REER), as of May 13 2024, the Japanese currency is at the cheapest level since at least 1989.

In addition, USDJPY seems to have diverged from short-term portfolio flow metrics, like interest rate differentials. For example, the divergence started already appearing at the beginning of April 2024 but became particularly pronounced after the BOJ intervention in early May.

Finally, at the end of April, USDJPY reached overbought levels not seen since December 2001. These were some of the technical reasons why the MOF eventually instructed the BOJ to intervene and buy JPY in the open market. 

However, in our opinion, the MOF has other more structural reasons for wanting to see the Japanese currency stable, at the minimum. Facing exceptionally low returns on capital at home, thanks to the ultra-low rate policy the BOJ pursued to inflate the economy and meagre prospects for equity capital appreciation, Japanese private capital has chosen to invest abroad.

This private capital exodus abroad seems to have been a clear trend in the last two decades. The shocking part is that the MOF & BOJ intervention in the Autumn of 2022 did not seem to have affected this capital flight trend at all. 

A cheaper currency can help a country improve its external imbalance or revive its economy, thus potentially pushing its inflation rate higher. A trend of constant currency depreciation can pretty much do the opposite – wreck a country’s economy by undermining trust in its institutional and governance frameworks. It is likely that Japanese government officials at the MOF may fear that the currency depreciation trend would hit such a point of no return unless something is done to promptly stem or potentially even reverse it. 

Kishida meets Ueda

The BOJ, on the other hand, does not seem to have such concerns. For more than two decades, policymakers at the Central Bank have unsuccessfully tried to achieve their main mandate of price stability by getting the Japanese economy out of the spectre of disinflation. 

And then, in the early 2020s, we had the confluence of the Covid crisis and geopolitical tensions disrupting global supply chains and providing the structural base for a shift in the low inflationary period globally from which Japan also naturally started to benefit. 

Moreover, the Japanese currency started to weaken, fuelling the fire of Japanese inflation. This is ‘manna from heaven’ for the BOJ – a Japanese Central Bank Governor could realistically fulfil his primary mandate for the first time. BOJ governor Ueda is not going to let that slide, is he?

In early May, there seemed to have been a ‘routine’ meeting between PM Kishida and BOJ Governor Ueda. What was not routine, however, was that after the meeting, the governor’s tone concerning the currency’s effect on inflation suddenly changed. Only 11 days before, Ueda had said that “the yen’s recent fall did not have an immediate impact on trend inflation”; after the meeting with the PM, the governor said that the “BOJ may take monetary policy action if the yen falls affect prices significantly”. 

Currency impact

The MOF ultimately controls the currency and only instructs the central bank to transact on its behalf. As such, policymakers have already shown their card. Anyone who knows or has dealt with Japanese officials knows that once they have embarked on a project, they will keep going at it until it is complete or they have run out of options, sometimes, even if only out of ‘pure pride’. 

The BOJ is reluctant to raise rates, as that goes against its mandate. However, a central bank is never fully independent from the government, and there is inevitably some pressure on the BOJ to be more hawkish. Therefore, if a hawkish BOJ does not stem JPY weakness, then the MOF/BOJ will embark on another round of intervention. 

Empirical literature shows that unilateral foreign exchange intervention seldom works, though, to be fair, most of the studies are done for emerging market countries with limited FX reserves. Japan not only has a sizeable official stock of USDs, but it can also harness, in theory, the private stock of USDs. 

Moreover, it can quickly get a swap line from the Fed, with the intervention effectively becoming dual, and the chance of success increases substantially. So, Japan has options and still an opportunity to stem the weakness of its currency.

What about rates?

The BOJ can sound hawkish, but we suspect it will stick to its initial assessment of postponing raising rates as long as possible so as not to jeopardise its inflation mandate. 

The worst possible outcome remains one of accelerated inflation, with or without JPY weakness, which becomes ingrained and pushes inflation expectations in the opposite vicious cycle to what Japan experienced before (so higher, not lower). With the stock of debt multiple times its GDP, to combat this rise in inflation, Japan will find itself trapped, unable to raise rates sufficiently fast for fear of triggering a vicious debt cycle instead. 

Suppose the inflation cycle globally has turned on the back of shifting global supply chains, advanced manufacturing, AI, green energy capital investments, and geopolitical tensions. In that case, Japan will not be the only country facing the choice of a vicious inflation cycle on the one hand and crippling debt payments on the other. 

However, while in the preceding three decades it was emerging market countries that had to face that predicament, in the years to follow, it would be mostly developed countries because they are the ones that have substantially increased their debt stock. Japan may be the first one that the markets would force to act.

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