Japan’s Horrible GDP Data May Be Good For Stocks
Japan reported horrible GDP numbers this week. During the second quarter, Japan’s economy shrank by 6.8% on an annualized basis. This followed an equally unusual expansion in economic growth of 6.1% during the first quarter. The sharp rise in the first quarter and the slump in the second quarter were both caused by an increase in Japan’s national sales tax (from 5% to 8%), which took effect in April. Consumers loaded up on goods during the first quarter before the tax was introduced. They then spent much less during the second quarter to avoid the higher prices. Overall, Japan’s economy was more or less flat over the 12 months ending June 30th.
A three-percentage point increase in the sales tax was bound to have a significant negative impact on Japan’s economy. Nevertheless, with a budget deficit of more than 7% of GDP and a government debt to GDP ratio of nearly 250%, the government felt compelled to take some step to increase its revenues.
The government has also become very aggressive in its fight against deflation. Prices in Japan started falling in 1995 and falling prices have made Japan’s government debt problem even worse than it appears on the surface. If prices were rising, as they typically do in most countries, the government’s debt would be gradually inflated away. However, with prices actually falling, the opposite occurs. In real terms, the government debt becomes larger each year.
In order to attempt to put an end to deflation, Japan’s central bank, the Bank of Japan (BOJ), launched an extraordinarily aggressive program of fiat money creation in April 2013. This program is called Quantitative and Qualitative Easing, or QQE for short. Relative to the size of Japan’s economy, QQE is about three times larger than the Fed’s Quantitative Easing program was at its peak. Since the launch of QQE, the Bank of Japan’s assets have increased by 66%. Fiat money creation on this scale is extreme when compared with the experience of any other developed country since World War II. Moreover, the central bank has committed itself to continue creating fiat money at the current pace until inflation moves up to 2% and until the public comes to believe that inflation will remain at that level.
Thus far, QQE has been effective in pushing up prices. When it began, core CPI (consumer price inflation, excluding fresh food) was negative at minus 0.4%. By June this year, (excluding the effect of the consumption tax hike) it reached 1.3%. However, the main way in which QQE pushed prices higher was by pushing the Yen lower. The Yen fell by about 20% against the dollar once the market came to believe that the BOJ would introduce QQE. The lower Yen made the cost of imports rise and that lifted the overall price level in Japan. But, this process will only continue to push prices higher if the Yen continues to decline; and that is not happening. The Yen has been roughly flat now for the last year. Including the effects of the tax hike, CPI rose 3.6% in June. But those effects will disappear entirely next April once the tax hike ceases to distort the price data. The fact that the effect of both the weaker Yen and the tax hike are only temporary, suggests that the BOJ may have to increase the amount of money it creates still further later this year in order to keep the inflation rate rising.
On August 1st, the Governor of the Bank of Japan, Haruhiko Kuroda, delivered a speech entitled, “Japan’s Economy: Achieving 2 Percent Inflation”. In it, he made the case that QQE is working and that inflation in Japan will move up to and remain at 2% starting sometime next year. I was not persuaded that the current fundamentals of Japan’s economy support that conclusion.
However, he also stressed the BOJ’s determination to achieve that outcome. He said, “I would like to emphasize that, under QQE, given the Bank’s clear and strong commitment to the 2 percent inflation target, it is a matter of course that the Bank will make adjustments if necessary to ensure the target is achieved.” By using the words “make adjustments if necessary”, Governor Kuroda is telling the world that the BOJ will not hesitate to increase the amount of fiat money it is creating through QQE if that is necessary to reach the 2% inflation target.
QQE may ultimately be successful in raising inflation and inflation expectation to 2%, but I am not sure that it can succeed in keeping them there. What is much more certain, however, is that if the BOJ does expand QQE still further, then the Yen will weaken, Japanese corporate profits will improve and the stock market will rise. This is a scenario where, at least for a short while, it would once again be relatively easy to make money in Japan. I believe this week’s horrible GDP report has made this scenario increasingly probable.
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