Everyone knows the Japan story: Weak growth, declining population, ongoing deflation, rinse, wash repeat, etc.
In a new note, Nomura presents a twist, which is that declining population could be what ultimately lifts Japan out of deflation, the idea being that declining population won’t just impact the demand side, but will impact the supply side as well.
A decline in the population is certainly a limiting factor for demand, with fewer people needing goods and
services, but it is also a limiting factor for potential output, with fewer people to make goods or provide services. Let us, for example, assume that younger people produce as well as consume, while older people keep consuming while producing nothing. This being the case, by the above kind of supply and demand logic, a sustained increase in the relative population of older people could be expected to encourage inflation, as that segment of the consuming population would continue increasing even as the working population declines. In considering the effect of demographics on the inflation rate, it is necessary to look at the effect on demand as well as on supply and compare the two.
First, let us consider the effect of a decline in the population on potential output. The population
of people aged 15-64, which constitutes the bulk of the country’s labour force, is projected to
decline at an average annual pace of 1% through 2020, in part owing to the effect of baby
boomers reaching retirement age from 2012. The Japanese economy will then enter a period of
rapid decline in the size of the labour force. Assuming that capex continues to grow at an average
annual clip of 3% and that total factor productivity increases in line with its average for the 2000s,
we calculate that Japan’s potential output would grow by an average annual rate of 0.5% or so
over the next 10 years (Figure 1). Then it’s just a matter of keeping the supply above that to start creating some inflationary pressure:
With the total population in decline, we think the Japanese economy is likely to see low growth.
That said, we do not think it is overly optimistic to anticipate growth in demand of about 1%. If
potential output grows at a rate of around 0.5%, as shown in Figure 1, then demand growth will
outstrip supply growth, with the result that the output gap will close and Japan will pull out of
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