In this post, we continue to validate our predictions of the rate of consumer price inflation (CPI) in Japan by the estimate for 2011. The Japan Bureau of Statistics has estimated the rate of CPI inflation as -0.3%. Now we have an estimate of labour force for 2011 and are able to compare the observed and predicted figures.
We have been following inflation in Japan since 2005 when our first paper on the Japanese economy was published and covered the period through 2003. We have revisited inflation in Japan in 2010 and confirmed the predictions of deflation as expressed by the negative GDP deflator. In this blog, we also reported on deflation (both CPI and GDP deflator) several times.
The case of Japan is the best illustration of our concept linking inflation to the change in labour force. (In a sense, all developed countries stay on the brink of deflation because of the threat of falling labour force.) Therefore we do not suggest the liquidity trap in Japan or any mistakes in monetary policy (inflation does not depend on monetary policy as our model shows.). The evolution of inflation is completely driven by the change in labour force. This is an unfortunate situation for Japan since the level of labour force can only fall in the long run due to the decreasing working age population.
Previously, we carried out an estimation of empirical relationship between the change rate of labour force, dlnLF(t)/dt, and inflation, p(t).
First, we test the existence of a link between inflation and labour force. Because of the structural (likely related to definition and measurement procedure) break in the 1980s, we have chosen the period after 1982 for linear regression. By varying the lag between the labour force and inflation one can obtain the best-fit coefficients for the prediction of CPI inflation, p(t), according to the following relationship (updated with new data since 2009):
p(t) = 1.39dlnLF(t-t0)/dt + 0.0004 (1)
where the time lag t0=0 years; standard errors for both coefficients are shown in brackets. Figure 1 (upper panel) depicts this best-fit case. (The period after 2003 is highlighted.) There is no time lag between the inflation series and the labour force change series in Japan. Free term in (1), defining the level of price inflation in the absence of labour force change, is statistically undistinguishable from zero.
A more precise and reliable method to compare observed and predicted inflation consists in the comparison of cumulative curves. Short-term oscillations and uncorrelated noise in data as induced by inaccurate measurements and the inevitable bias in all definitions should be smoothed out in cumulative curves. Any actual deviation between two cumulative curves persists in time if measured values are not matched by the defining relationship.
The predicted cumulative values shown in the lower panel of Figure 1 are very sensitive to the free term in (1). For Japan, the cumulative curves are characterized by complex shapes. There are periods of intensive inflation and a deflationary period. The labour force change, defining the predicted inflation curve, follows all the turns in the measured cumulative inflation.
One can conclude that relationship (1) is valid and the labour force change is the driving force of inflation. Statistically, the evolution of the overall level of consumer prices in Japan is fully defined by the change in labour force. Hence, no other variable or process can affect the change in price. Otherwise, the statistically reliable link would not exist.
Having the projection of labour force borrowed from the National Institute of Population and Social Security Research, one can predict the future of CPI inflation in Japan. It will be decreasing to the level of -1% per year in 2050.
Conclusion: invite immigrants and start a baby boom today! Otherwise, the level of consumer prices in 2050 will be a half of that of today.
Figure 1. Measured inflation (CPI) and that predicted from the change rate of labour force. Upper panel: Annual curves. Lower panel: Cumulative curves between 1982 and 2011. A good agreement between the cumulative curves illustrates the predictive power of our model.
Figure 2. Scatter plot: predicted vs. measured rate of CPI inflation.
Figure 3. Projection of the labour force evolution between 2005 and 2050.
Figure 4. The rate of CPI inflation in Japan through 2050.