Is abenomics working?

Here we present  quantitative evidences that the effect of abenomics on CPI in Japan is invisibly weak, if any. Our quantitative model, which we presented at the conference “Inflation Developments after the Great Recession” hosted (December 2013) by the Deutsche Bundesbank and sponsored by the EABCN, is available as a CEPR working paper “Inflation, Unemployment, and Labor Force: The Phillips Curve and Long-term Projections for Japan”.   This model shows that the current surge in consumer prices is  an abenomics achievement, but the result of labour force increase started in 2011, i.e. before the start of the new monetary (and economic) policy introduced by Abe. Moreover, when the effect of increasing labour force fades away in a few months deflation in consumer prices will be back. It is worth noting that the GDP price deflator is still in the negative zone and that the headline CPI is a highly biased (up) measure of inflation not to be used by sane researchers.


At first, we present our model in detail. In this blog, we have already mentioned that Japan is the best illustration of our concept linking inflation/unemployment to the change in labour force. In our previous posts on the GDP deflator in Japan, we showed two cumulative curves for observed and predicted inflation since 1980. Here we revisit similar CPI curves also two more readings and conclude that our concept is quantitatively excellent. The underlying data have been borrowed from the OECD and Japan Statistics.


Using stata9 and allowing a structural break, we sought for the best-fit (in RMS sense) coefficients in the linear and lagged link between inflation and labour force. Because of the structural (measurement related) break in the 1980s, we have chosen the period after 1981 for linear regression, which is common for almost all economic studies related to Japan. By varying the lag and coefficients we have found the following relationship for consumer price inflation (CPI):


CPI(t) = 1.39dLF(t-t0)/LF(t-t0) + 0.0004            (1)


where the time lag t0=0 years; Figure 1 depicts this best-fit case. 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 close to zero but negative.


A more precise and reliable representation of the observed and predicted inflation consists in the comparison of cumulative curves (a version of CUSUM technique) shown in the lower panel of Figure 1. We always stress that the cumulative values of price inflation and the change in labour force are the levels of price and labour force, respectively. Therefore, the summation of the annual reading gives the original estimates of price and workforce, which when are converted into rates.


Another advantage of the cumulative curves is that all short-term oscillations and uncorrelated noise in data as induced by inaccurate measurements and the inevitable bias in all definitions are effectively smoothed out. Any actual deviation between these two cumulative curves persists in time if measured values are not matched by the defining relationship. The predicted cumulative values are very sensitive to free term in (1).


For Japan, the CPI cumulative curves are characterized by very complex and unusual for economics shapes. There was a period of intensive inflation growth and a long deflationary period. The labour force change, defining the predicted inflation curve, follows all the turns in the measured cumulative inflation with the coefficient of determination R2=0.99. The predicted and observed cumulative CPI curves are cointegrated and thus this estimate is consistent. For the annual estimates: R2=0.73. With shrinking population, and thus, labour force, the level of CPI will be falling through 2050 and likely beyond.


Now, we return to the current rise in the headline CPI and apply (1) to monthly readings of labour force and inflation. Figure 2 shows the change rate in labour force. One can observe the positive trend started in the middle of 2011 and will likely extend into the first quarter of 2014. Figure 3 compares the predicted and observed rate of inflation (year-on-year estimates for the monthly estimates) since 2010 and demonstrates that the current rise in the headline CPI is likely a short deviation from the long-term trend fully related to a small rise in the level of labour force, not the abenomics tools. Because of the overall ageing and depopulation this positive trend will not last long and the level of labour force will definitely fall. This fall will induce price deflation, as Figure 1 predicts.  


Figure 1. Measured CPI inflation and that predicted from the change rate of labour force in Japan. Upper panel:  Annual curves smoothed with MA(3). Lower panel: Cumulative curves between 1981 and 2012. The extremely accurate agreement between the cumulative curves illustrates the predictive power of our model. The cumulative curves are I(1) processes and we thus it was instructive to test them for cointegration. This test was successful.

Figure 2. The rate of change in labour force, dLF/LF, since 2010. Monthly readings are used and the year-on-year rate is calculated. 

Figure 3. Comparison of the measured inflation rate (y-o-y) and that predicted from the change in labour force.

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