Conditions for Breaking Free from Deflation Based on the GDP Deflator and Unit Labor Cost
July 2 (Monday) 2007
Hidetaka Yoneyama
Research Fellow
Summary
- When determining whether the Japanese economy has broken free from deflation, judgment is based on a comprehensive look at the movements of the consumer price index (CPI), the GDP deflator, the unit labor cost (ULC) and etc. At one point there was a rise in the CPI from the previous year, but it dipped soon after and is not expected to rise again until after summer (as a result of the surge in oil prices last year, oil products will hold down the CPI until summer). Meanwhile, the GDP deflator and ULC both remain down. This report will search for the conditions to escape from deflation by analyzing the movements of these two indices.
Conditions for Breaking Free from Deflation Based on Unit Labor Cost
First we take a look at ULC movements since the 90s. In 1998, the year when deflation became pronounced, the year-on-year decline in the ULC widened, and until 2003 the margin of decline increased each year. Though the margin of decline has shrunk since 2004, the recent figures are still barely in the minus.
The ULC is calculated by dividing workers’ income by production, and shows the cost of labor per one unit of production. This index can be changed to (worker’s income/labor time) / (production/labor time) = wages per hour/productivity per hour. As such, the ULC shows the ratio of wages and productivity. This relationship makes it possible to breakdown ULC movements into the movement of wages and the movement of productivity.
Breaking down the year-to-year movement of the ULC into these two elements shows that the productivity factor has consistently pushed the index down since the 90s. In other words, productivity consistently and continuously improved in the 90s, and this served to lower the ULC. On the other hand, the wage factor contributed to raising the ULC until 1997, but since 1998 (when deflation became prominent) it has pushed it down. In other words, in the beginning stages of deflation wages raised the ULC, but since then it has changed to being a factor pushing it down.
To interpret this from the side of companies, improving productivity cannot be the only response to deflation, and eventually there became no choice but to decrease wages. Until recently, both an increase in productivity and a decline in wages contributed to a decrease in the ULC.
Recently, the lowering effect of improved productivity on the ULC has somewhat weakened, while wages have transitioned into having a slight raising effect. As a result, the year-on-year margin of decline in the ULC from has become smaller. If this effect of wage increases becomes stronger and steadier, the ULC would end up rising.
In summary, in terms of the ULC, wage increases will become a stronger condition for breaking free from deflation than the margin of increase in productivity. Recently companies have more breathing room to increase wages, and though the pace is slow, the direction is towards this condition being met.
Conditions for Breaking Free from Deflation Based on the GDP Deflator
Next we examine the movements of the GDP deflator, which reflects price movements of the economy as a whole. Taking a look at the GDP deflator since the 90s, the year-on-year margin of decline increased starting in 1998, when serious deflation began. While the margin of decline began to shrink in 2003, recently the direction is again in decline.
The movements of the GDP deflator can be broken down into the labor cost per unit of production (worker’s income/real GDP, ULC) and profit per one unit of production (worker’s income/real GDP, unit of profit, UP). (This is from the relationship of GDP deflator = nominal GDP/real GDP ≒ (worker’s income + sales surplus and etc.) / real GDP).
Of these, the UP had contributed to raise the year-on-year GDP deflator until the beginning of the 90s, but since then it has almost entirely done the opposite. Meanwhile, the movements of the ULC have already been mentioned (in decline since 1998).
The following can be said about the movements of UP and ULC from the perspective of companies. Facing deflation, companies responded in the beginning stages (since the beginning of the 90s) only by lowering profit per one unit of production, but later (since 1998) they also began to reduce labor cost per unit of production (ULC). In other words, companies became faced with no choice but to deal with deflation by lowering labor costs in addition to profits.
The conditions for breaking free from deflation when looking at the GDP deflator are raising both ULC and UP, or having one rise enough to surpass a decline in the other. Can these kinds of conditions be fulfilled quickly? Raising both the ULC and UP at the same time would be quite difficult in general. For example, in the event of an increase in the intermediary input price, in the current environment where competition is intense and it is difficult to shift such a price increase to the price of the final product, it would be difficult for companies to secure the same level of profit. It would be even more difficult to increase the distribution of benefits among laborers.
In this way, from a look at the unit labor cost and GDP deflator, it seems that it will take a significant amount of time for both to transition into the positive and in doing so mark a complete victory over deflation. While the conditions have not yet been met, if the current economic growth extends over the long-term, it should be possible to slowly move in that direction.