JAPAN ECONOMIC WEEKLY

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JAPAN ECONOMIC WEEKLY Global Economic Research October 5, 27 Kazuhiko Ogata Japan Economist Global Economic Research + 81 (3) 324 8627 This document reflects the views of AllianceBernstein as of the

The views expressed may change at any time. References to stocks, securities or investments should not be considered recommendations to buy or sell.

1 JAPAN ECONOMIC WEEKLY Global Economic Research October 5, 27 Kazuhiko Ogata Japan Economist Global Economic Research + 81 (3) This document reflects the views of AllianceBernstein as of the dates cited. No representation or warranty is made concerning the accuracy of cited data. Nor is there any guarantee that any projection, forecast or opinion will be realized. The views expressed may change at any time. References to stocks, securities or investments should not be considered recommendations to buy or sell. The value of investments, and the income from them, can fall as well as rise and you may not get back the original amount invested. Past performance is not a guide to future performance. The value of overseas securities will be subject to exchange-rate fluctuations. Under no circumstances should this information be construed as investment advice. Nor should it be construed as sales or marketing material for any financial instrument, product or service sponsored or provided by AllianceBernstein or its affiliates or agents.

2 Japan Economic Perspectives Japan s Consumer Prices Continue to Pose a Conundrum for BOJ The Bank of Japan (BOJ) has worried about potential inflation for some time despite a stubbornly weak consumer price index (CPI). After all, the economy is extending its longest expansion in the post-war era and global commodity prices are soaring. However, even though it was just a matter of.1%, the core CPI kept clocking year-on-year declines in recent months, putting a hold on the BOJ s attempt to normalize interest rates. Patiently, the BOJ played a waiting game. But as an upturn in the CPI comes within reach, the name of the game seems to be changing because the price rebound will likely occur amid increasingly fragile consumption. Instead of worrying about inflation when the CPI is falling, the bank may now need to worry about faltering domestic demand even as the CPI rises. In this week s report, we will look into why consumption and CPI appear to be diverging at this juncture. Consumption Deteriorates Underscoring dormant consumer spending, the Consumption Composite Index declined for the second consecutive month in July. It held up somewhat in August, but this was largely attributable to a one-off factor, i.e. the effect of an extremely hot summer weather (Display 1). September figures will likely show another downturn, judging from weak department-store sales data for the month. We expect third-quarter consumption to be no more than flat from the previous quarter. That would represent a further slowdown in consumption growth from +.3% in the second quarter and.8% and 1.1% respectively in the two quarters before that. Employment growth remains solid, but average wage growth on an all-industries basis is sluggish, up only.1% year on year in August after a shocking 1.7% drop in July. The three-month moving average is -.9%, the worst showing in four years (Display 2). In addition, the positive effect of rising stock dividends, which have become an influential household revenue source in recent years, is dissipating due to a heavier income tax burden. Dwindling stock prices also dash hopes of support from households "wealth effect". The burden of taxes and rising gas prices has undermined consumer sentiment, leading to a lower rate of propensity to consume. The BOJ s quarterly Tankan survey for September, released earlier this week, clearly illustrated the weak consumption trend. The business conditions diffusion indices for consumer industries retail, services for individuals, food services and accommodation all deteriorated in September. In particular, the index for the retail industry tumbled to -14, the lowest level in nearly three years (Display 3). Input Costs Soar In general, falling demand tends to reduce the sellers pricing power. Interestingly, however, the reality at the moment looks to be the opposite. The Tankan survey showed that consumer industries are starting to regain pricing power, even in face of waning demand. The diffusion index for sales prices ( rising minus that of falling ) showed a further improvement in all consumer industries, e.g., the index for retail rose from June s -1 to, the best reading since It clearly suggests that consumer price deflation is ending (Display 4). But why should prices firm if consumption is so soft? In our view, consumer industries may have reached a stage where they have no other choice but to raise their sales prices in order to remain afloat due to soaring input costs. According to the diffusion index for input prices in the Tankan survey, the September reading of +18 for retail was the highest since The indices for individual JAPAN ECONOMIC WEEKLY 2 AllianceBernstein Fixed Income

3 services and food services and accommodations were the highest since comparable records began four years ago (Display 5). In considering the upward pressure on prices, of particular importance is that unit labour cost (ULC) is on the verge of turning positive. In the second quarter, its year-on-year change recovered to -.2%, the smallest fall in two years (Display 6). If the ULC turns positive, that would be a first since All of these factors suggest that the CPI should rise further into positive territory, although the latest figures show the core index slipped.1% year on year for the fifth consecutive month in August. We think it is reasonable to assume that CPI inflation will rise next year, and we are maintaining our inflation forecast of.3% for 28, compared with flat in 27. Mobile-Phone Charges Pose a Risk There are several wild cards. If retail gasoline prices, now scaling record highs, stay at current levels, the oil factor can boost CPI inflation by.2 percentage points in November and by an additional.1 percentage point in the first quarter of next year. This suggests that core CPI inflation may turn positive in the fourth quarter, although oil prices are difficult to predict with precision. Mobile phone charges are a downside risk. They were the main culprit of the so-called CPI shock in August last year. The latest uncertainty stems from a plan by KDDI, a leading carrier, to introduce new options in November, in which call charges could be slashed by 3% but handset prices could double or even triple. Speculation is mounting that the other two carriers, NTT Docomo and Softbank, would follow suit by the end of this year. As components of the core CPI, mobile phone charges account for 2.17% of the total, while the sale price of handsets accounts for only.5%. This means that the introduction of the new plans could have a maximum downward impact of.6 percentage points on CPI inflation, although it may have no impact at all, depending on how the Ministry of Internal Affairs and Communications adjusts the index for phone users participation in the new plan. In any event, the CPI trend is often open to interpretation. To the extent that some technical factors can mask any real changes in the underlying trend, the BOJ continues to face a big conundrum. Kazuhiko Ogata Global Economic Research October 5, 27 JAPAN ECONOMIC WEEKLY 3 AllianceBernstein Fixed Income

4 Display 1: Consumption Is Faltering Despite Temporary Bounce in August Consumption Composite Index (Index) 111 August Source: Cabinet Office and AllianceBernstein Display 2: Falling Wages Remain a Drag on Consumer Demand Regular Employment and Average Cash Salary (All Industries) (YoY % Change) 3 2 REGULAR EMPLOYMENT 1 (1) (2) (3) (4) TOTAL CASH EARNINGS (3-Month Moving Average) (5) Source: Ministry of Health, Labor and Welfare, and AllianceBernstein JAPAN ECONOMIC WEEKLY 4 AllianceBernstein Fixed Income

5 Display 3: Business Is Slowing in Consumer Industries Business Conditions Diffusion Index for Consumer Industries (BOJ Tankan) (Diffusion Index) 1 SERVICES TO INDIVIDUALS (1) (2) (3) (4) RETAIL FOOD SERVICES AND ACCOMMODATION (5) (6) Source: Bank of Japan and AllianceBernstein Display 4: Sales Prices Picking Up in Consumer Industries Diffusion Index on Sales Prices for Consumer Industries (BOJ Tankan) (Diffusion Index) RISING FOOD SERVICES AND ACCOMMODATION (1) (2) RETAIL FALLING (3) SERVICES TO INDIVIDUALS (4) Source: Bank of Japan and AllianceBernstein JAPAN ECONOMIC WEEKLY 5 AllianceBernstein Fixed Income

6 Display 5: Soaring Input Prices Are Pressuring Consumer Industries Diffusion Index on Input Prices for Consumer Industries (BOJ Tankan) (Diffusion Index) RISING FOOD SERVICES AND ACCOMMODATION RETAIL (5) (1) (15) FALLING SERVICES TO INDIVIDUALS (2) Source: Bank of Japan and AllianceBernstein Display 6: Unit Labour Costs Are on Verge of Turning Positive AllianceBernstein Estimate of Unit Labour Costs (YoY % Change) 4 2 (2) (4) (6) Source: Ministry of Health, Labor and Welfare, Ministry of Economy, Trade and Industry, and AllianceBernstein JAPAN ECONOMIC WEEKLY 6 AllianceBernstein Fixed Income

Outlook for the Japanese Economy in 2007

VOL2.NO.2 January 2007 Outlook for the Japanese Economy in 2007 Economic recovery surpasses Izanagi in length The economy is continuing its longest post-war economic recovery. Nearly five years have passed