January 30, 2015, 17:00 JST

Do you hear this sound of labor market tightening?

Looking at the December labor market data, we felt we could almost hear the sound of labor market tightening in Japan. Unemployment rate fell to 3.4%, 18 years low, and job offers to applicant ratio rose to 1.15, 23 year high. Even more remarkably, new job offers to applicant ratio rose as much as 0.13 point to 1.79. A single month rise of 0.13 point has not happened in Japan since 1976. New job offers to applicant ratio is important as it is a leading indicator of what to expect to happen in the labor market. 

 Source: MHLW, JMA.

The size of the single month jump in new job offers to applicant ratio does make us suspicious for statistical errors. However, as we pore over the details, there is nothing obvious. Overall new job offers increased by 5.6% year on year. Breakdowns by industry shows that it is the domestic side of the economy that are desparately trying to fill vacancies. In December, hotels and restaurants increased their new job offers by 17.7% year on year, the healthcare industry by 11.9%, retailers by 9.1%.

We also notice that the tightening in the labor market is coming as much from the supply of labor as from the demand for labor. In December 2014, new job applicants fell by 4.7% year on year. In fact, new job applicants have been consistently declining over the last few years while the new job offers has increased. 

 Source: MHLW, JMA.

Why is new job applicants declining? Well, for the obvious reason. Japanese working population is shrinking rapidly. In 2014, Japanese population in the age bracket 15-64 shrunk as much as 1.2 million persons. Japan is trying to make up for it through a higher labor participation from its elderly population, but it is apparently not enough. 

In our view, this tightening trend in the Japanese labor market is likely to continue, if not accelerate in the coming months. We can see more demand for labor in the pipeline. For example, manufacturers seems to be preparing to expand their production. In December, Japanese industrial production expanded by 1.0% month on month. In January 2015, manufacturers plan to expand it further by 6.3%.

 Source: METI, JMA.

In our view, these robust production plans have a good chance of being realized although it may take a little longer than manufacturers currently plan. Japanese exports has been expanding at a pace faster than the industrial production. While manufacturers may have some room to ship out of their inventory, their production needs to catch up if exports keep up their current pace. And if manufacturers do expand their production, they will need to employ more workers. 

 Source: METI, JMA.

In our view, we are likely to see a sizable tightening in the labor market in 2015. We expect to see unemployment rate to fall below 3% by the end of 2015.

What are less certain though is what would happen to wage growth and inflation. Despite the ongoing tightening in the labor market and rising inflation, we have hardly seen any sign of wage inflation yet.

 Source: MHLW, JMA.

However, as we look back in history, it is just a lag. Wage inflation will happen, it just lags behind economic activities and inflation. Such was the case during the oil shock incident in 1970s and also in the bubble years through 1989-91. Wage inflation typically lags behind CPI inflation by a year or two.  

 Source: MIAC, MHLW, JMA.

 Source: MIAC, MHLW, JMA.

It has been more than 2 years since Mr Abe became Japan's Prime Minister with an inflation flag and forced the BoJ to adopt 2% inflation target. It has been more than a year and a half since we last saw deflation in the CPI. Japanese populations should be starting to adjust their inflation expectation by now. With an historic tightening in the labor market, it is our prediction that we will see a visible wage inflation through the course of 2015.