Japan: Selected Issues

This Selected Issues paper examines implications for long-term bond yields in case of Japan. The analysis finds that so far, upward pressure on interest rates from high public debt has been offset by domestic factors, including a stable investor base with a preference for safe assets. As these effects could decline with population aging, yields could rise unless reforms are implemented to stimulate growth and reduce the public debt-to-GDP ratio. In such a scenario, long-term Japanese government bond rates would remain relatively low and stable. The paper also analyzes to what extent rising health care spending poses a fiscal risk to Japan’s economy.

Abstract

This Selected Issues paper examines implications for long-term bond yields in case of Japan. The analysis finds that so far, upward pressure on interest rates from high public debt has been offset by domestic factors, including a stable investor base with a preference for safe assets. As these effects could decline with population aging, yields could rise unless reforms are implemented to stimulate growth and reduce the public debt-to-GDP ratio. In such a scenario, long-term Japanese government bond rates would remain relatively low and stable. The paper also analyzes to what extent rising health care spending poses a fiscal risk to Japan’s economy.

Is Aging Deflationary?1

Japan has the most rapidly aging population in the world. This has implications for growth and fiscal sustainability, but the potential impact on inflation has been studied less. We use the IMF’s Global Integrated Fiscal and Monetary Model (GIMF) and find substantial deflationary pressures from aging, mainly from declining growth and falling land prices. Dissaving by the elderly supports aggregate demand, but also leads to real exchange rate appreciation from the repatriation of foreign assets. The deflationary effects from aging are magnified by the large fiscal consolidation need. A combination of, structural reforms, aggressive monetary easing, and fiscal consolidation can however offset these deflationary pressures, by raising inflation expectations and supporting growth.

A. Introduction

1. Japan is aging rapidly. Large gains in longevity and virtually no immigration imply “aging in fast forward.” Life expectancy is the highest in the world and baby boom generations (born in 1947–49) have started retiring in 2007. As noted in IMF (2012), the old-age population will continue to increase disproportionately in coming years, while the fertility rate declined markedly during the past decades. Some of the other advanced economies, as well as countries in the region, such as Korea and China will likewise experience pressures from the demographic transition in the near future.

uA03fig01

Working-age Population Change (1950-2050)

(Index 1950=100)

Citation: IMF Staff Country Reports 2013, 254; 10.5089/9781475563795.002.A003

Source: United Nations.

2. We analyze whether aging can be deflationary. The impact of population aging on growth and debt sustainability has been actively studied. However, the potential effects on inflation dynamics and the implications for monetary, fiscal, and structural policies have received considerably less attention. The extent to which structural factors affect inflation dynamics is a particularly pertinent question at this juncture as the country aims to emerge from deflation and revitalize the economy through comprehensive reforms.

B. Potential Effects of Aging on Inflation

3. Population aging could affect inflation dynamics by affecting relative prices, the output gap, and potential growth among other channels. In particular, deflationary pressures could arise from:

uA03fig02

Average Expenditure Share by Households Age Between 1995–2010

Citation: IMF Staff Country Reports 2013, 254; 10.5089/9781475563795.002.A003

Source: IMF staff calculations.
  • Changes in relative prices, including from land. A shrinking or aging population would lower the price of land (for example, because the elderly live in smaller houses). Land is not only a fixed factor of production, but also affects wealth and thereby consumer behavior. A decline in labor force participation affects real wages. The extent to which relative price changes occur between land, labor, and capital will depend partly on labor market characteristics—in Japan, wage growth has lagged productivity growth despite declining labor force participation and the absence of immigration. In addition, aging leads to secular shifts in consumption patterns as the elderly’s preferences differ from the young with less spending on housing, transportation and communication, and education and more spending on medical, utilities, and other consumption expenditures as the population ages (text chart). To what extent this shift affects inflation dynamics depends on the flexibility of supply to adapt to these changes. In turn, this may be affected by the extent to which there may be substitution from market to regulated prices, although this will be difficult to capture empirically.

  • Widening output gap from fiscal pressures. In many countries, advanced and emerging economies alike, aging will lead to higher government outlays on pensions and health care and a shrinking tax base. Coupled with elevated initial deficit and debt levels, the expectation of a rising risk premium or fiscal consolidation would lead to a sustained period of output growth below potential and deflationary pressures. In contrast, unsustainable government debt dynamics could increase inflation expectations in the absence of a credible medium-term fiscal consolidation plan. It should be noted though that projections for aging-related expenditures appear relatively modest in Japan—although new work suggests that health care spending could rise faster than previously expected (Kashiwase, Nozaki, and Saito, 2013)—and hence the fiscal channel will be driven mainly by the weak initial position.

  • Declining potential growth and private savings dynamics. Declining labor force participation rates and life-cycle savings effects could contribute to growth being below potential, or to potential growth declining. On the former, expectations of slowing demand in the future could lead firms to reduce investment today, leading to a widening output gap during the transition phase.

  • Life-cycle savings considerations could have wealth implications by affecting asset prices, including the exchange rate following repatriation of foreign investments. Most likely, these effects on potential growth and asset prices could affect prices of traded and nontraded goods differently, with the effect presumably more pronounced on the latter.

  • The composition of government spending will likely change as a result of population aging, possibly resulting in greater redistribution from young to older cohorts and therefore toward transfers from current and public investment, which could affect potential growth output and inflation dynamics.

  • Changes in policy objectives affected by political economy considerations. Young cohorts do not initially have any assets, and wages are their main source of income; they prefer relatively low real interest rates, relatively high wages, and relatively high rates of inflation. Older generations work less and prefer higher rates of return from their savings, relatively low wages, and relatively low inflation (Bullard, Garriga, and Waller, 2012). The latter will depend on institutional factors, for example the extent of pension indexation. As such, aging could affect the objective function of a central bank, with a lower weight attached to inflation. In contrast, Japan has recently adopted a higher inflation target to be achieved through aggressive quantitative and qualitative monetary easing, to some extent defying the political economy hypothesis, or at least suggesting that this can be trumped by other economic considerations if the country has been stuck in deflation.

C. A Model-Based Evaluation

4. We use the IMF’s Global Integrated Monetary and Fiscal (GIMF) model to quantify some of these channels and analyze policy options. In the confinements of GIMF, we are not able to capture all of the channels above. Specifically, changes in consumption patterns and political economy considerations are not included in the simulations. We have extended GIMF to include land, as a factor of production, a source of wealth, and consumption good. Since GIMF does not allow for an explicit incorporation of retirement decisions we impose the decline in labor force participation based on the UN’s demographic projections. Likewise, the extent to which retirees dissave is imposed in the model and the decline in the ratio of private savings to GDP is assumed to be about 3.5 percentage points between 2012–40, similar to Hoshi and Ito (2012) where aggregate savings to GDP decline from about 2.8 percent in 2012 to about −1.3 percent in 2040.

5. The model has some limitations. In principle, monetary policy will react endogenously to any effects of aging on inflation consistent with the central bank’s objective function, although there remains the open issue to what extent this will be effective under the zero-lower bound. Therefore, to isolate the effect of aging on inflation one would need to keep monetary policy constant. However, this can only be imposed in GIMF for a few periods as otherwise the model would become unstable. As such, any deflationary effects from aging will be observed in the simulations through both the policy rate and the inflation rate.

6. We find that aging is deflationary through lower labor force participation and declining land prices, real exchange rate appreciation, and a gradually rising sovereign risk premium as private savings decline (Figure 1).

Figure 1.
Figure 1.

Effects of Aging and Macroeconomic Policies on Selected Macroeconomic Variable

(Percent deviation from initial steady state unless otherwise noted)

Citation: IMF Staff Country Reports 2013, 254; 10.5089/9781475563795.002.A003

  • Population aging exerts deflationary pressures. Real GDP contracts as the labor force shrinks. Land prices continue their slide, putting further downward pressure on inflation, both directly and indirectly by lower production costs. Without a more aggressive policy rule, despite a reduction in the “shadow” policy rate of about 20 basis points, inflation falls by about 10 basis points. Government debt increases due to the fall in nominal GDP.

  • Dissaving by the elderly exerts further deflationary pressures through real exchange rate appreciation. Interestingly, one might suspect that dissaving by retirees would be inflationary: as aggregate supply declines, aggregate demand remains supported, as can be observed in panel 2 of Figure 1. However, repatriation of foreign savings leads to real exchange rate appreciation, more than offsetting this channel.

  • A rising risk premium adds further deflationary pressures. As private savings start to fall, while the government financing requirement remains high, the government needs to increasingly tap foreign investors leading to higher government bond yields. The combined effect leads to a decline in inflation of about 30 basis points on average between 2013–30 despite a decline in the “shadow” policy rate of about 60 basis points on average during the same period.

7. A bold package of reforms that includes fiscal consolidation, structural reforms, and aggressive monetary easing can overcome these deflationary pressures.

  • Fiscal consolidation by itself further adds significant deflationary pressures, more than those from aging. As mentioned, unlike other advanced economies, aging does not exert significant fiscal pressures in Japan. In contrast, the fiscal consolidation needs stem from the high initial debt and deficit levels, with rising social security benefits and health care spending adding only modest further pressures over the medium term. To put debt on a downward trajectory relative to the baseline, it is assumed that 1 percent of GDP fiscal consolidation takes place for each year during 2015–20 through a mix of higher consumption taxes and cuts in government spending. Even though this would avoid the rise in the risk premium, consumption and land prices decline markedly, exerting downward pressure on the “shadow” policy rate2 and inflation. Fiscal consolidation more than offsets the decline in private savings leading to further accumulation of net foreign assets. This channel may also be relevant for other countries that experience medium- to long-term fiscal pressures, even if the labor force participation rate remains relatively unchanged.

  • Combining fiscal consolidation with structural reforms and aggressive monetary easing to achieve the new inflation target can offset the effects of aging. In the simulation, it is assumed that structural reforms raise potential growth by 25 basis points by 2015 and by 50 basis points by 2018. In combination with a credible adoption of the 2 percent inflation target, pursued by aggressive monetary easing, such a policy package has substantial benefits by overcoming the deflationary effects of aging, while supporting growth and fiscal sustainability.

D. Conclusions

8. Although aging tends to exert deflationary pressures, these can be overcome with a full package of reforms that include medium-term fiscal consolidation, structural reforms, and aggressive monetary easing. Such a package generates powerful economic synergies. Given aging pressures, monetary policy will likely have to stay accommodative for an extended period of time, although the extent to which this is the case depends critically on the credibility of the central bank’s policy rule. Measures that directly address the effects of population aging are likely to be most effective. These include stimulating labor force participation by females and the elderly as well as greater options for immigration.

References

  • Bullard, J., C. Garriga, and C.J. Waller, 2012, “Demographics, Redistribution, and Optimal Inflation,” Presented at the 2012 BOJ-IMES Conference Demographic Changes and Macroeconomic Performance, Federal Reserve Bank of St. Louis.

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  • Hoshi, T. and T. Ito, 2012, “Defying Gravity: How Long Will Japanese Government Bond Prices Remain High?NBER Working Paper Series, WP 18287 (Cambridge, Massachusetts: National Bureau of Economic Research).

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  • International Monetary Fund, 2012, August, “Options for Pension Reform in Japan,” in Japan: Selected Issues, IMF Country Report No. 12/209, Washington DC.

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  • Kashiwase, K., M. Nozaki, and I. Saito, 2013, “Health Care Spending and Financing in Japan,” IMF Working Paper, forthcoming.

1

Prepared by Dennis Botman (APD), Derek Anderson and Ben Hunt (both RES).

2

The “shadow” policy rate is defined as the rate that would be observed in the absence of the zero-lower bound.

Japan: Selected Issues
Author: International Monetary Fund. Asia and Pacific Dept
  • View in gallery

    Working-age Population Change (1950-2050)

    (Index 1950=100)

  • View in gallery

    Average Expenditure Share by Households Age Between 1995–2010

  • View in gallery

    Effects of Aging and Macroeconomic Policies on Selected Macroeconomic Variable

    (Percent deviation from initial steady state unless otherwise noted)