In this note, I will adopt a two-pronged approach. Firstly, I will do a round-up of the domestic scene in Japan and more specifically the inflation outlook as well as the subsequent outlook for a possible interest rate hike by the BOJ come February or March. Secondly, I will take a look at the international perspective on Japan, where there has been a recent flurry of news items on the Japanese economy, where especially the low Yen and the carry trades are very hot topics.
In(de)flation Moving Forward?
The Japanese economy simply does not seem to be able to catch a break these days. Back at the beginning of this month the BOJ had to dissapoint financial markets yet again as the central bank failed to find room for an interest rate hike. The reason for this is not slow growth per se but more specifically the persistent sluggishness in consumer spending figures which mirrors a domestic economy where demand seems locked in towards a steady decline despite a very low nominal interest rate of 0.25%. This also materializes itself in inflation figures which can be seen in a broad as well as a narrow perspective. In terms of the former, Japan has been fighting deflation for over 5 years now with annual inflation rates in deflationary territory (2002-2005) or very close to it. In 2006 the Economist Intelligence Unit estimated consumer inflation as running at 0.3%. Looking at the latter, where are we headed as we enter 2007 then? Sadly for Japan it now seems likely that deflation is steadily becoming a once more a reality rather than a pessimistic outlook. The first aspect of this is the growth in household spending which on a y-o-y basis in 2006 probably will come in very close to stagnation or even perhaps enter negative territory. The recent retail sales figures from December bode ill for the general bullish perspective on Q4 2006 and consequently for the prospects of a BOJ raise. On a monthly basis retail revenues fell 0.2% seasonally adjusted but more importantly sales on a y-o-y basis fell 0.3% which according to Bloomberg constitutes the biggest decline in the last eight months. Retail sales are of course here used as a proxy for household spending and I am beginning to wonder whether in fact the expected increase in consumer spending in Q4 2006 will in fact not be a dissapointment. Remeber also here that the second aspect of the decline in inflation going into 2007 is the recent dip in headline inflation as a function of dropping oil prices. As Artim pointed out recently the general outlook on oil prices still points to structural forces which will tend to push up prices but for reasons explained by Artim the headline inflation rate has been dropping throughout Q4 2006 and is set to continue into 2007. This of course only acts as another hit on Japan's already depressed inflation rate which incorporates the headline account in the overall inflation measure. Looking at what this means for inflation rates in Japan and subsequently the BOJ's ability to raise in February Takehiro Sato from Morgan Stanley estimates, for example, that the CPI index will go into negative territory as early as February-March on the back of a faster than expected decline in oil prices.
However, what about the tightening labour market and the prospects of wage-push inflation as the unemployment rate keeps on drifting down, from the current level of around 4%? To scrutinize this Edward had an illuminating post over at Bonobo Land which quotes a recent article from the FT. The FT article highlights some important points on the Japanese labour market which, based on the commentary by Hiroshi Shiraishi, economist at Lehman Brothers, directs us towards an explanation for the absence of wage push inflation in Japan. The first point relates to the global phenomenon of how corporate attention increasingly is biased towards shareholders which results in the increasingly missing link between booming corporate profits and wages. This is also reflected in the global labour arbitrage argument.
The second point relates to the compostional change in the labour force as large cohorts of highly paid baby-boomers are retiring and being replaced by much thinner young cohorts, who are obviously much lower paid. Also, the labour market reforms now mean that the seniority element in wages is now much less evident, and especially in the lower skill groups. The sum total of all this is to put an inbuilt and systematic downward pressure on wages.
Thirdly, and finally, Shiraishi points to the weak yen and how this is squeezing domestic companies' foreign buying power and especially inhibiting small companies from raising wages. However, despite these strutural economic aspects another data point caught my eye in the form of the jobs-to-job seeker ration which is at 1,08 to 1,00 and marks the tightest condition since 1992 according to the FT article. So it seems that although jobs indeed are present in the economy the supply side is having trouble following the demand side which I might add is pretty strong circumstantial evidence that at least a part of the labour market tightening process in Japan is due to the sustainened process of ageing and thus compositional change of the population structure and labour force.
In conclusion, what we have here then is hardly promising signs for Japan in terms of the domestic economy's ability to produce signs which would reinforce the BOJ's willingness to justify domestically a raise in the interest rate come February or March.
A Tough Burden to Carry?
A related topic to the one discussed above about how persistingly low figuers for consumer spending and thus inflation holds off the BOJ from raising is the issue of the low Yen and subsequent the Yen carry trade which exploits the interest rate spread between low yielding Japanese government debt and high yielding debt instruments (e.g. US treasuries). The first lesson here is that the transmission mechanism is very direct between economic data and the Yen because it all relates to whether investors expect the BOJ to raise or not. Consequently, Bloomberg (linked above) reports that the Yen recently fell to a fourth year low against the Dollar on the back of the dissapointing retail sales figures cited above. More importantly, the carry trade flows and outlook seem increasingly fortified as investors continue to bet short on the Yen at the same time as expectations point to both the Fed and ECB being likely to widen the interest rate spread thus making the carry trade even more profitable. In essence the carry trade follows a perfectly rational investor approach albeit with the subtle point that it basically hinges on low volatility and thus the expectation that the high-rated currency in the carry trade will not devalue. At a later point I will go into more detail here at GEM as to what drives the carry trade. Meanwhile, the carry trade is still the source of much debate and concern in Europe and the US, a debate which translates into a concern about an unhealthy build-up of leverage. Essentially, the concern boils down to the way in which a growing number of leading European politicians and economists are voicing their dissatisfaction with what they call the undervalued Yen relative to the Euro, and thus have started to protest about the inability of the BOJ to respond to what they perceive as being the sound fundamentals of the Japanese economy and thus raise rates to unwind the carry-trade, and even more importantly in a more general global perspective to contribute to the perceived need to mopup excess global liquidity. The criticism of Japan and concern over the carry trade and excess liquidity is for example becoming operationalized in the forthcoming G7 forum. So as we gear up for the G7 meeting next week we can be sure that especially European representatives will voice their concern over the distorting nature of Japanese monetary policy. However, what does this mean? To what extent will and indeed should investors correct to the messages from G7 and more importantly will the signals transmitted by the high lords at G7 really have an impact on the Yen?
In a recent research note, Robert Alan Feldman from Morgan Stanley points to the warranty of due attention to the signals coming from G7. It is of course always good to listen, but what should not escape our attention in this case is that this would not be the first time the G7(8) forum had tried to talk up the Yen. In fact they even tried to do this as recently as last September,and at that point all the talk ended up being cheap. In fact, I am going to pick a whee bit on Feldman here since he himself, only a few days ago, suggested that investor corrected to the fundamentals of the Japanese economy instead of the rhetorics of the BOJ and the Japanese policy makers. Surely this goes for G7 rhetorics as well, or what?