Japan's Reflation Versus BOJ Caution

Morgan Stanley’s chief economists discuss how policymakers in China, Japan and the European Union are addressing slower growth, deflation or the return of inflationary pressures.

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Seth Carpenter: Welcome to Thoughts on the Market. I'm Seth Carpenter, Morgan Stanley's Global Chief Economist.

Well, a lot has changed since the second quarter and the last time we did one of these around the world economics roundtable. After an extended pause, the United States Federal Reserve started cutting rates again. Europe's recovery is showing, well, some mixed signals. And in Asia, there's once again increasing reliance on policy support to keep growth on track.

Today for the first part of a two-part conversation, I'm going to engage with Chetan Ahya, our Chief Asia economist, and Jens Eisenschmidt, our Chief Europe economist, to really get into a conversation about what's going on in the economy around the world.

It's Tuesday, September 30th at 10am in New York.

Jens Eisenschmidt: And 4pm in Frankfurt.

Chetan Ahya: And 10pm in Hong

Seth Carpenter: So, it's getting to be the end of the third quarter, and the narrative around the world is still quite murky from my perspective. The Fed has delivered on a rate cut. The ECB has decided that maybe disinflation is over. And in Asia, China's policymakers are trying to lean in and push policy to right the wrongs of deflation in that economy.

I want to get into some of the real hard questions that investors around the world are asking in terms of what's going on in the economy, how it's working out, and what we should look for. So, Chetan, if I can actually start with you. One of the terms that we've heard a lot coming out of China is the anti-involution policy.

Can you just lay out briefly for us, what do we mean when we say the anti-involution policy in China?

Chetan Ahya: Well, the anti-evolution policy is a response to China's excess capacity and persistent deflation challenge. And in China's context, involution refers to the dynamic where producers compete excessively, resulting in aggressive price cuts and diminishing returns on capital employed.

And look, at the heart of this deflation challenge is China's approach of maintaining high real GDP growth with more investment in manufacturing and infrastructure when aggregate demand slows. And in the past few years, policy makers push for investment in manufacturing and infrastructure to offset the sharp slow down in property sector.

And as a result, a number of industry sectors now have large excess capacities, explaining this persistent deflationary environment. And after close to two and a half years of deflation, policy makers are recognizing that deflation is not good for the corporate sector, households and the government. 

And from the past experience, we know that when policymakers in China signal a clear intention, it will be followed up by an intensification of policy efforts to cut capacity in select sectors. However, we think moving economy out of deflation will be challenging. These supply reduction efforts may be helpful but will not be sufficient on their own. And this time for a sustainable solution to deflation problem, we think a pivot is needed – supporting consumption via systematic efforts to increase social welfare spending, particularly targeted towards migrant workers in urban China and rural poor. But we are not optimistic that this solution will be implemented in scale.

Seth Carpenter: So that makes sense because in the past when we've been talking about the issue of deflation in China, it's essentially this mismatch between the amount of demand in the economy not being sufficient to match the supply. As you said, you and your team have been thinking that the best solution here would be to increase demand, and instead what the policymakers are doing is reducing supply.

So, if you don't think this change in policy, this anti-evolution policy is sufficient to break this deflation cycle – what do you see as the most likely outcome for economic growth in China this year and next?

Chetan Ahya: So, this year we expect GDP growth to be around 4.7 percent, which implies that in the back half of the year you'll see growth slowing down to around 4.5 percent because we already grew at 5.2 in the first half. And, going forward we think that, you know, you should be looking more at normal GDP growth set because as we just discussed deflation is a key challenge.

So, while we have real GDP growth at 4.7 for 2025, normal GDP growth is going to be 4 percent. And next year, again, we think normal GDP growth will be in that range of 4 percent.

Seth Carpenter: That whole spiral of deflation – it's sort of interesting, Japan as an economy has broken that sort of stagnation or disinflation spiral that it was in for 25 years. We've been writing for a long time about the reflation story going on in Japan. Let me ask you, our forecast has been that the reflationary dynamic is there. It's embedded, it's not going away anytime. But, on the other hand, we basically see the Bank of Japan as on hold, not just for the rest of this year, but for all of next year as well.

Can you let us know a little bit about what's going on with Japan and why we don't think the Bank of Japan might raise interest rates anytime soon?

Chetan Ahya: So, Seth, at the outset, we think BoJ needs still some more time to be sure that we are on that virtuous cycle of rising prices and wages. Yes, both prices and wages have gone up. But it is very clear from the data that a large part of this rise in prices can be attributed to currency depreciation and supply side factors, such as higher energy prices earlier, and food prices now. And similarly, currency depreciation has also played a role in lifting corporate profits, which then has allowed the corporate sector to increase wages.

So, if you look at the drivers to rise in prices and wage growth as of now, we think that demand has not really played a big role. To just establish that point, if you look at Japan's GDP, it's just about 1 percent higher than pre-COVID on a real basis. And if you look at Japan's consumption, real consumption trend, it's still 1 percent below pre-COVID levels.

So, we think BoJ still needs more time. And just to add one more point on this. BoJ is also conscious about what tariffs will do to Japan's exports, and economy; and therefore, they want to wait for some more time to see the evidence that demand also picks up before they take up a policy rate hike.

Seth Carpenter: So, one economy in deflation and policy is probably not enough to prevent it. Another economy that's got reflation, but a very cautious central bank who wants to make sure it continues. Jens, let's pivot now to Europe because at the last policy meeting, President Lagarde of the ECB said pretty, pretty strongly that she thinks the disinflationary process in Europe has come to an end. And that the ECB is basically on hold at this point going forward.

Do you agree with her assessment? Do you think she's got it right? You think she's got it wrong? How could she be wrong, if she’s wrong? And what's your outlook for the ECB?

Jens Eisenschmidt: Yeah, there a ton of questions here. I think I was also struck by the statement as you were. I think there is probably – that's at least my interpretation – a reference here to – Okay, we have come down a long way in terms of inflation in the Euro area. Rather being at 10 percent at some point in the past and now basically at target. And we think; I mean, we just got the data actually, for September in. It's more or less in line with what we had expected up again to 2.3. But that's really it. And then from here it's really down.

Very good reasons to believe this will be the case. We have actually inflation below target next year, and the ECB agrees. So that's why I think she can't have made reference to what Liza had because the ECB itself is predicting that inflation from here will fall. So, I think it's really probably rather description of the way traveled. And then there may be some nuances here in the policy prescription forward.

So, for now we think inflation will undershoot the target. And we think this undershoot has good chances to extend well into the medium term. So that's the famous 2027 forecast. The ECB in its last installment of the forecast in September doesn't disagree. Or it's actually, in theory at least, in agreement because it has a 1.9 here for 2027. So, it's also below target.

But when asked about that at the press conference, the President said, yes, it's actually, very close to 2. So, it really cannot be really distinguished here. So, from that perspective, policy makers probably want to wait it out. In particular for the October meeting, which is not a forecast meeting, we don't expect any change.

And then the focus of attention is really on the December meeting with the new forecast. What will 2028 show in their forecast for inflation? And will the 1.9 in [20]27 actually be rather 1.8? In which case I think the discussion on further cuts will heat up. We have a cut for December, and we have another one for March.

Seth Carpenter: Of course, very often one of the things that drives inflation is overall economic growth and a key determinant of economic growth tends to be fiscal policy. And there we've got two big economies very much in the headlines right now. Germany, on the one hand, with plans to increase spending both on infrastructure and on defense spending. And then France, who's seen lots of instability, shall we say, with the government as they try to come up with a plan for fiscal consolidation.

So, with those two economies in mind, can you walk us through what is the fiscal outlook for Germany, in particular? Is it going to be enough to stimulate overall growth in Europe? And then for France, are they going to be able to get the fiscal consolidation that they're looking for? How do you see those two economies evolving in terms of fiscal policy?

Jens Eisenschmidt: Yeah, it's of course neither black or white, as you know. I think here we really look into the German case specifically, as the clear case where fiscal stimulus will happen. It may just not happen as quickly, and it's a very trade open economy. So, it's very much exposed to the current headwinds coming out of China for one. Or also U.S. tariffs. So, from that we conclude our net-net is actually, yes, there is textbook fiscal stimulus. So, basically domestic demand replacing less foreign demand.

So that's fine, but just not enough. We see essentially better growth in Germany, but that's more cyclically driven. But it was; it just would not be enough for what you would normally think given the size of the fiscal stimulus, which is enormous. But it will also take some time, this fiscal stimulus to unfold.

On the other side in France, as you rightly ask, how much consolidation are we going to get? I think the answer has to be very likely less than what the last – or the previous Prime Minister has had planned. So, all in all, that gets us into a situation of a country that lacks a clear economic policy structure, a clear governance structure; tries to – on a very fragile parliamentary majority – tries to consolidate the budget. Probably gets less consolidation going forward than what would be desirable. And, you know, here is sort of – not really...

It's been muddling through a little bit. This is probably a good description of the approach here in France, and we actually have on the lack of a clear economic policy agenda and still some fiscal consolidation. We have actually lackluster growth in France for this year and next.

Seth Carpenter: Okay, so what I'm hearing you saying is inflation seems likely to come down and probably undershoot their target causing President Lagarde and the ECB to reconsider how many cuts they're going to do. And then growth probably isn't going to be as stimulated by fiscal policy as I think lots of people in markets are hoping for.

Chetan, Jens, thanks for joining us.

And to the listeners, thank you for listening. Be sure to turn in tomorrow where I'm going to put Michael Gapen, Morgan Stanley’s Chief U.S. Economist on the hot seat, talk about the U.S. and maybe one or two more economies around the world.

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