Should policymakers be worried about the continued surge in underlying price increases?
Japan’s headline inflation reached a four-decade high in February as the economic recovery continued amid supportive monetary and fiscal policies and a surge in tourism. While lower energy prices reduced inflation in recent months, underlying momentum in core prices, which exclude fresh food and energy, has also strengthened further, reaching a four-decade high of 4.1 percent in April.
Rapid price gains are rarely desirable, but Japan is an exception after bouts of deflation since the late 1980s and early 1990s. Now, there are three reasons for hope that the world’s third-largest economy is at a turning point and that the Bank of Japan may finally be able to sustain inflation around its 2 percent target:
While inflation was initially triggered by the global energy and supply-chain crisis rather than strong underlying demand, there are increasing signs that price pressures are proving to be broader and more durable.
The annual ‘shunto’ negotiations between labor unions and major companies signal agreement on larger-than-expected wage gains that better keep up with rising prices.
Business surveys show a sustained increase in inflation expectations, which is likely to influence corporate price-setting.
These factors, however, are accompanied by important caveats, which would make it difficult to sustain this inflation. The expected wage boost may not be enough as small and medium-sized enterprises that employ more than 70 percent of workers are less profitable and may not be able to afford sufficiently large pay increases.

In addition, a weakening of the global economy could strengthen the yen, making exports less competitive and potentially returning Japan to low inflation or deflation. And household surveys indicate inflation expectations remain well below 2 percent. In our latest staff report, we project inflation to remain above the 2 percent target until the end of next year, driven by the continued surge in tourism and delayed effects of yen depreciation.

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