Is Japan winning the war against deflation?

Tokyo core CPI logs fastest gain since 1992

Core consumer prices in Tokyo, a leading indicator of nationwide inflation, rose to a 22-year high in April, fresh evidence that the Bank of Japan (BoJ) is making progress in its war against deflation.

"I see this as a very positive development as there were concerns that businesses wouldn't be able to pass on the tax hike to consumers, and clearly they were," Martin Schulz senior economist at Fujitsu Research Institute told CNBC on Friday.

Schulz says the data show the government has been successful is squeezing deflation out of the economy.

"Now the big thing is how they will deal with inflationary environment - and that will be more difficult than beating deflation," he said, noting that wages need to rise further to compensate for higher prices.

Women shop for umbrellas at a store in Tokyo, Japan.
Tomohiro Ohsumi | Bloomberg | Getty Images

Core consumer prices in the capital city rose 2.7 percent on year in April, the fastest gain since 1992 as an increase in Japan's sales tax drove up prices across the board.

The impact of the consumption tax hike is estimated to have boosted the reading by 1.7 percentage points. On April 1, Japan hiked its consumption tax to 8 percent from 5 percent, the first increase in 17 years, as part an effort to curb the nation's massive public debt.

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The increase in the core consumer price index, which excludes volatile fresh food prices but includes oil products, was slightly less than economists' median forecast for a 2.8 percent rise and followed a 1.0 percent gain in March.

Following the data release, Japanese Finance Minister Taro Aso said things are proceeding well in Japan's efforts to shake off deflation.

However, Izumi Devalier, Japan economist at HSBC, does not regard the latest inflation reading as particularly encouraging.

"The rise in Tokyo CPI from 1 percent to 2.7 percent is entirely due to the tax hike, underlying inflation is flat," Devalier said, noting that if the estimated inflation boost from the April tax hike is subtracted, April's CPI reading was unchanged from the previous month.

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While the risk of falling back into deflation is receding, Japan is far away from reaching the 2 percent inflation target in a sustainable manner, she said.

"We haven't seen the virtuous feedback loop where wage hikes lead to an increase in spending, which gives rise to inflationary pressures and allows businesses to raise prices further," she said.

"When the feedback loops breaks down you have a rise in prices with no improvement in income," she added.

Real wages, which take into account consumer inflation, dropped 1.9 percent on year in February, down for an eighth straight month, according to Reuters.

Prime Minister Shinzo Abe and his government have been publicly pressuring companies to raise wages, which is seen as a crucial factor to complement massive monetary and fiscal stimulus to try to pull the economy out of deflation.

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BoJ: To ease or not to ease?

Economists remain dived on their expectations for further monetary easing by the BoJ.

The central bank has stood pat on policy since delivering unprecedented stimulus in April last year, pledging to double base money via aggressive asset purchases.

Izumi expects the BoJ will step up monetary stimulus as early as July through boosting purchases of government bonds and risky assets.

"The BoJ is going to be cautious about taking it foot off the gas. The last time they switched from easing to tightening, in 2006, it raised criticism that their move was premature. They are going to be careful not be overconfident," she said.

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Junko Nishioka, chief economist at RBS Securities Japan, on the other hand, expects the central bank to keep monetary policy on hold for the remainder of the year.

"The BoJ has observed that mindset for inflation expectations has been changing - and the economic conditions are improving in line with their outlook," she said.

"Unless financial market condition changes dramatically - I don't think they will take additional action," she added.