Japan’s October inflation report showed that the impact of sales tax hike on inflation has been somewhat muted so far, as we expected (Figure 1). Headline inflation remained steady at a low of 0.2% y/y in October, shrugging off the impact of a tax hike. Removal of fresh food items in CPI saw core inflation was slightly firmer at 0.4% y/y in October, from 0.3% y/y in September. Meanwhile, core inflation, which excludes both fresh food and energy items, was more resilient at 0.6% y/y in October, same as in September.
The Japanese government pulled the trigger last month to hike the consumption tax in the country by another 2% to 10%. Contrary to previous tax hike in 2014, which resulted in significant volatility in inflation, this time it is expected to have a smaller impact. A recall of 2014 experience revealed that headline inflation almost doubled in the month the tax was increased (headline CPI rose by 3.4% y/y in April, up from 1.7% y/y in March 2014). Similar effects were also seen in core measures.
Figure 2: Further Breakdown of Inflation Components Revealed Opposing Forces (% y/y)
Source: CEIC, Continuum Economics. Note: figures in brackets are the respective weights of individual components.
While a sales tax hike will likely exert an upward force on inflation, various government measures to cushion the impacts on Japan’s economy will offset part of these upward forces. Earlier this year, lower mobile phone charges already trimmed some upward pressure on inflation. In October, in an attempt to expand child care support and boost the country’s low birthrate, the government started to make pre-school education free. That saw the education component in CPI down by 7.8% y/y in October, offsetting part of the price gains due to tax hike (Figure 2). Moreover, lower energy prices compared to last year have also dragged on headline inflation.
Overall, we expect headline inflation to remain muted at 0.6% in 2020 and slightly higher at 0.8% in 2021. Core inflation will likely be firmer at 0.7% in 2020 and 0.8% in 2021. Japan’s steady, albeit low, inflation is unlikely to move the needle for the BoJ in our view. The Bank has been quite cautious in topping up stimulus so far, sticking to verbal interventions. Recent stabilization in the markets, such as progress on a U.S./China phase one trade deal and JPY returning to a more comfortable level, may have provided the BoJ with some breathing room. The 10y JGB yield was also higher, at around -0.1%. We believe the Bank is likely to maintain its cautious stance with current policy settings unchanged unless there is further deterioration of economic conditions.