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Wednesday, February 21, 2007

Japan In The Front View Mirror

This week the Japanese economy has suddenly become the centre of everyone's attention, and just today we have the news that the Bank of Japan has finally bitten the bullet, and gone for a further 0.25% increase in its overnight lending rate. However I cannot help having the unfortunate feeling that everyone is so busy eagerly looking forward (to the recovery, the end of the carry trade, or whatever) that they are making the glaring and rather irresponsible error of forgetting to check on what has been happening behind, and in the only all too recent past.

The G7, as everyone by now probably knows, has just reasserted it's faith in the view that the Japanese economy is well on course to recovery. According to the official statement:

“Japan’s recovery is on track and is expected to continue. We are confident that the implications of these developments will be recognized by market participants”

Now this is a strange statement, since there are plenty of indications coming out of Japan that there are subtsantial doubts about this, and particular there are doubts about the resilience of domestic consumption in the current recovery, as Claus has already ably explained in two excellent posts (here and here). Since Claus will comment further on the details of the current decision, what I would like to do in this note is step back a bit, and reflect upon some aspects of the situation which should give us all cause for serious thought.

In particular there is the issue of deflation, and the danger that Japan may once more fall back into the deflation trap. I say once more, since at the present time I am already getting a strange feeling of deja vu, since few seem to remember that the current approach was tried and found wanting once before, back in 2000. Paul Krugman writing at the time had this to say:

So what if last Friday the Bank of Japan finally ended its "zero interest rate policy" (yes, ZIRP)? After all, it's only a quarter-point rise, in a faraway country that doesn't interest most Americans now that it no longer seems a dangerous competitor. And yet I would not be surprised if future economic historians look back at Friday's move as the beginning of the end for an era, and not just in Japan.

For one thing, this move by the Bank of Japan is a much bigger deal than you might think, because of its potential impact on expectations. By raising interest rates, even slightly, when the economy is still depressed, the B.O.J. in effect signals anyone in Japan who might be feeling stirrings of exuberance that it is likely to step on the brakes in earnest if the economy actually shows any signs of booming, or if consumer prices start to rise even slightly.


All of this is now of course simply history, but it is the sort of history for which many market participants - as opposed to academic economists who follow the Japan problem - seem to have remarkably short memories, and yet the consequences of that history remain, and are it seems, once more coming back to haunt us. As is well known the BoJ subsequently had to back away from the premature 2000 attempt to 'normalise' interest rates, but it seems that little has been learned from that experience. In fact, as is even less-well remembered, this failure constituted the second dent in the BoJs credibility as a deflation fighter. I say the second dent, since it is important to keep in mind that there was an earlier one, and this dent wasn't produced by the the failure to prevent the rise in asset prices that took place in Japan in the late 1980s and which gave rise to the eventual bubble. No, I am talking here about an episode which too place during the years between 1990 and 1995, during which period, according to a later consensus, the BoJ consistenly failed to act swiftly and decisively enough in lowering rates in order to try to prevent deflation occuring in the first place.

The locus classicus of this consensus is a short but influential paper by Ahearne et al (Preventing Deflation: Lessons from Japan's Experience in the 1990s. Alan Ahearne; Joseph Gagnon; Jane Haltmaier; Steve Kamin, Federal reserve Board, International Finance Discussion Papers, June 2002), which was widely read and quoted upon (and notably in the present context by Stephen Roach himself) during the the 2002-03 'deflation watch' period in the US, since it was seen as a central piece of acquired doctrine. Given the importance of all this I will now take the liberty of quoting the paper abstract in full (although reading the paper itself is strongly recommended):

This paper examines Japan’s experience in the first half of the 1990s to shed some light on several issues that arise as inflation declines toward zero. Is it possible to recognize when an economy is moving into a phase of sustained deflation? How quickly should monetary policy respond to sharp declines in inflation? Are there factors that inhibit the monetary transmission mechanism as interest rates approach zero? What is the role for fiscal policy in warding off a deflationary episode? We conclude that Japan’s sustained deflationary slump was very much unanticipated by Japanese policymakers and observers alike, and that this was a key factor in the authorities’ failure to provide sufficient stimulus to maintain growth and positive inflation. Once inflation turned negative and short-term interest rates approached the zero-lower-bound, it became much more difficult for monetary policy to reactivate the economy. We found little compelling evidence that in the lead up to deflation in the first half of the 1990s, the ability of either monetary or fiscal policy to help support the economy fell off significantly. Based on all these considerations, we draw the general lesson from Japan’s experience that when inflation and interest rates have fallen close to zero, and the risk of deflation is high, stimulus, both monetary and fiscal, should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity.

Note the last sentence in particular: when the risk of deflation is high "stimulus, both monetary and fiscal, should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity". And where exactly are we right now? Well it is hard to be certain, but certainly there is a widely held view that the risk of Japan falling back into deflation is not a negligable one.


Now one of the key episodes in the whole lamentable Japan deflation affair took place in the period between May 1994 and January 1995. As Ahearne et al note, the BoJ was at the time busying itself selling the idea that the worst of the long recession was over and that a new phase of economic recovery was on the point of opening up:

The BOJ maintained this (the low interest rate) policy stance unchanged through 1994, as hints of recovery began to emerge. In May 1994, the BOJ observed in its Quarterly Bulletin (pp. 32-33) that “Japan’s economic growth appears to have stopped weakening, against the background of progress in capital stock adjustment as well as the permeation of stimulative effects of monetary and fiscal policies to date.” By November, the BOJ noted that the economy was “recovering gradually,” with all categories of spending showing strength, and long-term interest rates moving up in apparent response.

Ring any bells anyone?

The anticipated recovery, of course, did not materialise as envisioned, there was a sharp slump in equity values and the BoJ was forced to respond by reducing its official discount rate to 0.25% in September 2005, at which level it remained until being lowered essentially to zero in 1999.

There is another difficulty which is also associated with the current consensus narrative on Japan, and that is associated with the current value of the yen. In a useful piece in the Financial Times yesterday, David Pilling (who is generally an excellent Japan watcher) drew attention to the way in which many would seek to put pressure on the Japanese authorities to do something to facilitate an upward movement in the value of the Yen:

There is one more element to add to this potent mix. In the past few weeks, Tokyo has come under pressure from European – though not US – officials over the weak yen which, in trade-weighted terms, is at 20-year lows. Some European finance ministers have linked the issue to Japanese interest rates being 5 percentage points below those in the US and the UK. As well as making Japan’s exports “unfairly” competitive, the criticism goes, the wide differential has fuelled the so-called carry trade, encouraging people to convert cheap yen into higher-yielding foreign assets.

Now let's just think about all this for a moment. Japan is being encouraged to raise rates, not primarily because of the internal needs of the Japanese economy, but in order to address possible problems being caused by the very low (some would say undervalued) level of the yen, and to help ease concerns about the impact of the ensuing carry trade. Fine. But what I ask if this tightening (or as some would say 'normalising') process only serves to send Japan back into deflation again? Well at the very least we would be back with ZIRP, and with it would come another prolonged period of carry-trade activity, with the likely additional consequence that the yen would be lead to weaken even further, as confidence in the BoJ and the Japanese economy suddenly ebbed, and as a further outflow of funds from Japan occured.

And just in case all this isn't enough, we might like to think about the work of Lars Svensson. Lars is Professor of Economics at Princeton University, and is one of the experts on that strange phenomenon known as the liquidity trap, which is of course intimately related with the deflation question, and about which much heart searching has been going on in recent years. So what does Lars have to say about possible policy methodologies for exiting from a liquidity trap (which is of course one of the problems which has been ailing Japan):

"In an open economy, the Foolproof Way (consisting of a price-level target path, currency depreciation and commitment to a currency peg and a zero interest rate until the price-level target path has been reached) is likely to be the most effective policy to raise expectations of the future price level, stimulate the economy, and escape from a liquidity trap. It is the first-best policy to end stagnation and deflation in Japan."
From the abstract of the paper Monetary Policy and Japan's Liquidity Trap (January, 2006).

Now let's leave aside at this point the throny question of whether the 'foolproof path' is as foolproof as it actually seems in the absence of any convincing analysis as to why the problem is such a protracted one in Japan (as well as the associated issue of just who exactly the 'fools' are that Lars would seek to protect us against in framing the idea in this way), the important point to note here is that the best advice one of the world's leading experts on how to handle Japan's problems can give is that they should systematically depreciate the currency, and then hold it down with some sort of peg. He is absolutely clear, allowing a rise in the value of the yen would simply raise expectations of a continuing weakness in prices (and remember this was also Krugman's point back in 2000) and hold Japan firmly in the grip of deflation. So those who now talk about the yen being currently 'undervalued' would do well to bear this in mind. Simply egging the yen upwards will only perpetuate deflation and send Japan careering back towards the re-introduction of ZIRP, which would of course only fuel the carry trade even more, and so on, and so on.

In closing, just three simple points. The first comes from David Pilling's piece mentioned above:

On one side of the debate, many academic economists argue that it is ludicrous even to consider raising rates now. Stripped of energy costs – the normal practice in other advanced economies – Japanese prices are still falling. Few textbooks, to put it mildly, advocate tightening at such a juncture.

Rarely has the distinction been more stark, there is a complete disparity between the advice and thinking of theoretical macroeconomists, and that of policy makers, central bankers, and market analysts. We are, of course, about to get to see who is in fact right (economics has the virtue of being a science which refers to a real world, so spin can only go so far), and my only hope is that one way or another the consequences of any error being committed at the present time are not too serious.

Secondly, lurking behind all this, as I have been indicating, lies the mirky question of why precisely deflation has been plagueing Japan for so long now. Only yesterday Stephen Roach served us up what must still be the consensus view on the situation:

The difficulty Japan is having in extricating itself from a post-bubble deflation may well be emblematic of deeper problems that continue to afflict the world’s second-largest economy. This same difficulty may also be having an important bearing on Japan’s competitive prowess. The damage from the bubble may well have been so wrenching and so fundamental to the system that it simply may be asking too much of Corporate Japan to rise quickly from the ashes and hold its own against the rapid emergence of China, the intense determination of Germany, and the solid gains evident by exporters elsewhere in the developing world.

So the problem stems, on this account, from the difficulties being encountered in extricating Japan from post bubble headaches. But this bubble burst some 18 years ago now. Really I fail to find this a very plausible account, and especially in the light of the fact that in recent years Japan has introduced wide reaching and extensive structural reforms (so yes, the centrality of structural reforms hypothesis is also under test here). As is by now well known to all our regular readers, Claus and I have been advancing another hypothesis, related to demography, Japan's ageing population, and the secular downward trend in the internal consumption GDP share. There is a hypothesis, it seems to fit much of the data reasonably well, and yet there is a a remarkable lack of enthusiasm for even considering this possibility. One notable exception here is MS's Robert Alan Feldman, who as Claus has been noting (and here), has been struggling with the 'something funny' feeling about the Japan consumption pattern. Methinks he is on the point of getting to the heart of the matter. Keep on scratching Robert!

Finally, there is the issue of what will happen to BoJ credibility if they have actually gotten this all wrong. Here I can do no better than cite Hidenao Nakagawa, secretary general of the Liberal Democratic Party (as quoted in this Bloomberg article)


The government's ``chilly, tacit acceptance of the move was based on the reasoning that the BOJ would be left accountable for any subsequent slowing of the economy,'' said Shinichi Ichikawa, chief strategist at Credit Suisse Group in Tokyo.

So the BoJ will remain accountable. Be warned! You are all playing with fire here, and I hope you realise it, since the livelihood and well-being of many millions of people depends on getting this one right.

Tuesday, February 20, 2007

Central Bankers and Political Pressures

Sorry I've been away for a while: too much work chasing too little time.

Now this interview in the FT today with Barney Frank, Democratic chairman of the House financial services committee, is reasonably interesting. Frank is worried about any possible decision by the Federal Reserve, following the lead of Ben Bernanke, to introduce inflation targeting as policy:

In an interview, Mr Frank told the FT that Mr Bernanke “has a statutory mandate for stable prices and low unemployment. If you target one of them, and not the other, it seems to me that will inevitably be favoured.” Mr Frank noted that Alan Greenspan, the former Fed chairman, always resisted an inflation target on the grounds that it would reduce his operational flexibility. “I think Alan Greenspan was right not to do that in the 1990s,” Mr Frank said. The lack of a formal inflation target helped Mr Greenspan probe how low unemployment could fall without generating inflation.

This interview follows a piece in Bloomberg yesterday Central Banks Face Rising Pressure From Politicians which covers some similar ground at a more general level:

When politicians tried to pressure former European Central Bank President Wim Duisenberg, he used to say: ``I hear, but I do not listen.'' These days, a growing number of central bankers worldwide are hearing a lot -- and some are listening. The Bank of Japan refrained from raising interest rates last month in the wake of government pressure. The autonomy of banks from Ecuador to India is under attack. French presidential candidates are demanding the ECB meet a goal for growth.

All of this raises a number of issues. In the first place the US debate seems potentially to be a bit muddled if you look at the Frank quote, since in the first place there are the genuine loss of flexibility concerns of Alan Greenspan (which I personally have a lot of sympathy with) and then there is the targeting of unemployment as a separate issue.

Obviously any rate call decision involves some sort of trade off between inflation and growth, and this is always very tricky, but of course the issue that is generally being raised is a political one about the ability of the central bankers to take decisions that the politicians would like to take, and here, normally, I would side with the central bankers.

But things aren't really what they used to be on this front, since the central bankers, via the framework of the G7, have been embarked for some time now on a rate 'normalisation' process which often seems to belie both the inflation objectives (Trichet's citing of money supply numbers, rather than the actual inflation data, for example) and run the danger in some areas of generating sub-par growth (the eurozone, Japan).

Also the attempt to portray Japan's recent decision as a politically inspired one is strange, becuase on many counts it could be seen as responding to economic fundamentals, and Japan's inflation (which is again hovering dangerously close to the deflation level) would hardly call for a series of rate rises at this point.

The underlying problem is, of course, the level of global liquidity, and what to do about this (things like the carry trade) but if the central bankers persist with what many could consider to be an unreal strategy, then the danger really is there that they can lose credibility, and this would be, of course, the point where the politicians once more start to enter stage left. So the situation is a little preoccupying. One symptom of the problem was the recent G7 declaration on the Japan recovery:

“Japan’s recovery is on track and is expected to continue. We are confident that the implications of these developments will be recognized by market participants”

Belief in the Japanese recovery seems to have converted itself into more or less a statement of faith, with almost quasi religious undertones (although some would doubtless call this spin).

Interestingly Maria Demertzis, of the Nederlandsche Bank, has an interesting piece on Central Bank communication practices over at the new Euro Intelligence site. She clearly doesn't get into the underlying economic fundamentals aspect of the present situation, but she does have some timely points about the dangers of spin doctoring, and in favour of the ever present need for flexibility, an argument which is presented of course from a very different perspective than that of Berni Franks.

My point therefore, would be that it is perhaps difficult to keep doing a good job if you are left with little to no room for manoeuvre. Circumstance will some times warrant some flexibility. I would let the experts then decide when and how much that flexibility should be.

And the risk of spin-doctoring is augmented if the demand for communication exceeds the supply of information because your emphasis shifts entirely from the message you are trying to convey, to the way you are trying to convey it. My point is that one should be aware that requests for more transparency or for communication go hand in hand with a greater risk for miscommunication.


This is I would say the big issue, the central bankers have left themselves with little room for manouevre, and economic realities may soon force them to change discourse, whilst in the meantime they have fallen into the trap of engaging in a certain amount of "spin-doctoring". Worrying.

Japan: To Raise or Not to Raise, That is the Question

Well in some ways this is an interesting week in Japan. The Boj has to take a decision on whether or not to raise interest rates. As Claus Vistesen says in an aptly titled post, this is just too close to call. Nonetheless I will stick my neck out just a little, I don't think they will raise, but I wouldn't attach a very high level of certainty to this, since there are a lot of pressures in both directions. But the underlying issue is one of asymmetric risk (ie the presence of so many downside factors, plus the need to do something on the fiscal front). Nevertheless I a may well be wrong, since the international pressures on Japan at this point are enormous. If they do raise I am categorically of the opinion that this would be a BAD decision, and indeed bending to political pressures rather than going by economic fundamentals.

I won't dwell more on this here, since Claus has already covered the ground in two excellent posts on Global Economy Matters (here and here).

What I will do is draw attention to an intersting piece from the FT Japan correspondant David Pilling. Pilling offers an interesting rundown of the history of Japanese central banking and monetary policy since the bursting of the bubble at the end of the 1980s. He also draws attention to the crucial dilema now facing Japan:

On one side of the debate, many academic economists argue that it is ludicrous even to consider raising rates now. Stripped of energy costs – the normal practice in other advanced economies – Japanese prices are still falling. Few textbooks, to put it mildly, advocate tightening at such a juncture.

Furthermore, sceptics say, the BoJ’s central scenario on which it bases monetary policy is patently failing to come to fruition. The bank has said it expects profits gradually to feed through to wages and consumption, exerting upward pressure on prices. But wages have barely budged, as companies have held tenaciously on to their earnings. Although consumption grew strongly in the fourth quarter, as revealed in the GDP numbers, that merely cancelled out an equally sharp drop in the previous three months.


As he says many academic economists argue that it is ludicrous even to consider raising rates now (and I would be among these I guess) but on the other hand:

Mr Yamakawa at Goldman says there are big risks to the BoJ’s policy objectives if it does not raise rates this time. “If it doesn’t move, the markets will receive a clear-cut message that the BoJ will not increase rates until it sees very definite signs of a recovery in consumption and the CPI. That means it would be waiting until everybody, including the politicians, was happy.”

But waiting for what he calls the “full set” of data confirming Japan’s transition from a deflationary to an inflationary economy “risks a distortion in the process of asset price formation”, Mr Yamakawa says. In particular, if markets conclude that rates will stay at 0.25 per cent for another six months, the carry trade is likely to swell further, increasing the impact of any sudden reversal.


I think this is only partly right, the risk to asset prices is not in Japan, but elsewhere (via the carry trade) and this is why there is so much pressure on Japan.

There is one more element to add to this potent mix. In the past few weeks, Tokyo has come under pressure from European – though not US – officials over the weak yen which, in trade-weighted terms, is at 20-year lows. Some European finance ministers have linked the issue to Japanese interest rates being 5 percentage points below those in the US and the UK. As well as making Japan’s exports “unfairly” competitive, the criticism goes, the wide differential has fuelled the so-called carry trade, encouraging people to convert cheap yen into higher-yielding foreign assets.

The issue came up at this month’s Group of Seven finance ministers meeting in Essen, although the final communiqué contained no direct demand that Japan should act. Some bond traders speculated that Mr Fukui may have helped head that off by hinting that Japan would raise rates soon.


So the risk here is that the BoJ may be forced into taking a bad decision (and against all sound macroeconomic advice) for political reasons, but these political reasons would be external and not internal ones. This is not the basis for sound monetary policy, and is a likely recipe for a loss of central bank credibility inside Japan, with unknown subsequent consequences. As Pilling notes since gaining independance back in 1998 the BoJ has already made one bad call (by starting to raise rates back in 2000, only to be forced to backtrack as deflation persisted), can it really now afford to make another one?

One last detail, and one which makes me lean towards the idea that the BoJ will continue to hold, the US situation. Now as Pilling notes:

The bank could be further emboldened by recent strength in the stock market and increasing evidence that the US economy, on which Japan depends for exports, will not fade nearly as quickly as once feared.

But if we look at the latest set of housing data from the US the position is by no means as clear as it was only last week:

Construction of new homes and apartments plunged by 14.3 percent in January, the Commerce Department reported Friday. The bigger-than-expected drop left construction at a seasonally adjusted annual rate of 1.408 million units, the lowest level in nearly 10 years.

Now don't get me wrong, the US economy is clearly not set on any kind of downward tailspin course, but it does seem that the immediate outlook is a little weaker than some had been hoping for. And the Japanese are deeply sensitive to any indications of ongoing weakness in the all important US consumer market, and this is the reason I feel that they will most probably come down on the side of caution.

Update: this piece in Bloomberg seems to confirm my view to some extent, certainly the markets are not anticipating a change, and comments from Japanese Finance Minister Koji Omi stressing the importance of central bank policy supporting economic growth seem to confirm this. Also the suggestion that Bank of Japan Governor Toshihiko Fukui will judge not only what's good for the economy but also what's good for the reputation of the central bank can be read in both directions. We will see.


Economic and Fiscal Policy Minister Hiroko Ota today said consumption is basically flat and it's up to the BOJ to decide policy. She declined to say whether the government will exercise its right to ask the bank to delay any decision to raise rates.

Export Dominated Growth In Germany and Japan

Well it is now more or less official, growth in the fourth quarter was largely a story of strong export performance in both Germany and Japan. Domestic consumption remained congenitally weak in both cases.


In Germany, as Bloomberg reports:

Booming exports drove an unexpected acceleration in German economic growth in the fourth quarter, capping the best year for Europe's largest economy since 2000. Sales abroad jumped 6 percent from the third quarter, the Federal Statistics Office in Wiesbaden said in a detailed report on the fourth quarter today. Private consumption rose 0.3 percent. The economy grew 0.9 percent after 0.8 percent expansion in the previous quarter

As the Federal Statistics Office makes clear growth was largely a story of exports (and the domestic capital expenditure necessary to fuel them) and demestic consumer demand (when you strip out an element for the advance purchasing influenced by the VAT hike) was virtually flat:

As regards GDP use, growth in the fourth quarter of 2006 was based both on domestic and foreign demand, as was the case in the quarter-on-quarter comparison. However, also in a year-on-year comparison, the particularly dynamic foreign trade contributed by far more to the economic upturn in the reference quarter than did domestic demand: The continuing demand from abroad produced two-digit growth rates, which were even much higher for exports (+15.9% in real terms) than for imports (+10.3%). The resulting export surplus (net exports) contributed 2.8 percentage points to economic growth. As mentioned above, the strong increase in exports was positively influenced by belated declarations received in foreign trade statistics.

The 15.9 % y-o-y increase in exports is large indeed, and does raise the question as to such whether such rates of increase can be sustained going forward.

In the case of Japan, again as Bloomberg points out:

Japan reported an unexpected trade surplus for January, buoyed by a 50 percent surge in exports to China and a drop in oil imports.The surplus was 4.4 billion yen ($36 million), compared with a deficit of 353.5 billion yen the same month a year earlier, the Ministry of Finance said in Tokyo today. Exports climbed 18.9 percent, twice as fast as economists expected.

So here again the increase in exports is pretty massive - 18.9% y-o-y - and the same sustainability issues arise. What is strange about all of this is how few commentators seem to be picking up on the underlying picture.

Thursday, February 08, 2007

BoJ: No Hurry To Raise Rates

Bank of Japan policy board member Hidehiko Haru has underlined what most Bonobo readers should already know, that internal consumption in Japan is week and that there's no threat that rising prices will cripple economic growth. Conclusion: there's no hurry to raise rates:

``Given that there's no evidence of any inflationary risk, there's no need to rush,'' Haru, 69, said today in a speech to business executives in Shizuoka city, Japan. ``Gradual adjustments will be needed and will be made based on improvements in the economy and prices.''

Governor Toshihiko Fukui and his policy board colleagues last month held the key overnight lending rate at 0.25 percent in a 6-3 vote, with most members saying they need more evidence prices will keep rising and consumer spending will improve. Fukui described data released since the decision as mixed, as exports and industrial production both surged to records while inflation slowed and household spending fell more than expected.

``Haru is basically saying there's no sense of urgency on policy,'' Katsunori Kitakura, chief treasury dealer at Chuo Mitsui Trust & Banking Co. in Tokyo. ``I don't think the BOJ will raise rates this month.''


Meantime he still doesn't seem to have gotten the full picture that this may be an ongoing structural issue with an ageing population, and he continues to hope for a 'turnaround' at some point:

``While the improvement in the household sector has been delayed, it is highly likely conditions will improve going forward,'' Haru said. ``Rising pressure on wages will steadily increase as labor shortages intensify.''

Wages fell 0.6 percent in December, the biggest drop in 16 months, the labor ministry said last month. Salaries increased only 0.2 percent last year, or about 5,500 yen ($45).

Wednesday, February 07, 2007

G7: Why All the Pressure on Japan?

The Group of Seven industrialized nations is meeting in Essen, Germany, later this week, and despite the fact that there are a lot of people trying hard to suggest otherwise, it appears that the topic of global liquidity will be high on the agenda.

Now what I think it is interesting for people to think about is why this is. Why does the yen loom so large in people's thoughts (even though there is no evidence whatsoever of Japanese intervention in currency markets)? Why is the Yen at such low levels? And why does the BoJ find it so difficult to raise interest rates. If you can answer these questions you will be a long way along the road towards understanding the current global economic conjuncture, IMHO.

Just to help you out, of course, Claus Vistesen had a couple of pointers on the GEM blog (and here).

Basically Japanese economic growth looks extremely shaky right now. Yesterday Bloomberg reported that the leading index (which offers a broad based reading of future economic activity) fell for the second month running, and by a significant amount to a reading of only 25%. This does not look good. And at the same time unemployment continues to run at an extremely low level, in part for demographic reasons.

So what I can't understand is why people want to keep putting pressure on Japan (well I can understand, the carry trade and all that), but I can't understand why more people are not able to think about this situation, about why it is happening, and about what the long term implications are.

Simply pushing for the BoJ to raise interest rates is only going to push Japan back into deflation, and why anyone would want that outcome is beyond me.

Thursday, February 01, 2007

No signs of Inflation in Japan

by Claus Vistesen

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?