Monetary policy makers are often difficult to gauge, but looking forward to the BOJ meeting come next week (Monday and Tuesday) one thing seems fairly certain; the BOJ is going to hold off its guns yet again. That was also the conclusion reached by Bloomberg as they conducted a survey of 39 economists who unanimously called it a holding operation.
On the face of it the BOJ's dilemma is not so different from other central banks' in the sense that it is impossible to focus on growth and inflation at one and the same time. Yet, Japan is obviously a bit different since in this particular case there is the issue of continuing deflation in US style core prices while headline inflation is shooting up through the roof. For a visualization of the level form of price developments I can refer to my most recent assessment of the Japanese economy. What the graph below shows is the widening spread between the core-of-core price index (formally in deflation) and core price index.
It can easily be seen that this is not for the faint of heart and to make things worse wholesale inflation rose to a 27 year high in June. This suggests that a lot of inflation is creeping up through companies' supply and value chains. Now, there are arguments as to why we should not expect the link between wholesale and consumer prices to be particularly strong but it still confronts the BOJ with a set of quite un-welcome fundamentals.
In a slightly wider perspective it is quite interesting to witness the extent to which the BOJ's governing council under the charge of, the recently appointed, Masaaki Shirakawa basically has continued to tread the path laid out by Fukui. This would be the path then, on which extreme caution is exercised towards moving on rates in either direction. The interesting part of this is that Shirakawa was appointed as the main man of the BOJ, after a spectacle worthy to the annals of theatricals, in the expectation that he would hawkishly re-commence the very slow process of interest rate normalization in Japan. So far he and the rest of the council have been disappointing the hawks; that is, unless you take a whole new perspective of central bankers' propensity to gradualism.
In a more fundamental light the BOJ has simply recognized that the recovery is not on track and that the wisest road to take would be not to flog consumers (and companies) with increasing rates in the context of stagflation. More specifically, the ghost of deflation still lingers and I think it is safe to say that the BOJ is not inclined to risk increasing rates in order to combat inflation only to face the probability of re-introducing ZIRP. This would be a mirror image to the Bundesbank like attitude epitomized by the ECB and its recent preemptive move against inflation in a situation where the economic edifice is visibly crumbling. It is still too early to tell which of the global central banks that will emerge in the right. I think the BOJ is right not to push rates up but the current environment is not an easy one; that is for sure. Another thing which is making it a bit easier for the BOJ is the sudden abating of external pressures. In this way, it was only back in 2006 and beginning of 2007 that consecutive G8 meetings were ripe with comments to talk up the Yen and to push Japan to normalise rates more quickly. As a much welcome breather for the BOJ recent G8 meetings have not been concerned about the Yen but about the USD, the Fed's easing of monetary policy, and the inflationary nexus it represents as a result of USD pegging emerging markets.
One could however easily imagine the spotlight turning to Japan again at some point in the near future. In such a case and assuming that headline inflation continues to post accelerated increases it is not too difficult to see how the BOJ once again may be finding itself in a tight spot.
In the context of real economic fundamentals it is not very difficult to find ammunition for why the BOJ might want to hold off its plans to raise rates. I have an overview here as well as Edward provides additional pointers with his most recent write up on exports. The only bright spot was the impressive surge in machinery orders which provide pretty strong grounds for corporate capex in the immediate future. In a recent speech, governor Shirakawa also emphasised the risks to the economy. In particular, he made the following point in the context of terms of trade which is important to latch on to ...
"The deterioration in the terms of trade that results from rises in energy and materials prices leads to an outflow of real income, as Japan depends heavily on imported resources. This exerts downward pressure on corporate profits and reduces households' purchasing power. Although business fixed investment and private consumption remain firm, due attention should be paid to the possibility that the weakening of the economy's capacity to generate income will result in weaker domestic private demand."
Now, at this point I would be understanding if readers are a little bit confused. As such and if terms of trade deterioration is the main problem would it not make sense to raise rates to pump up the currency and thus increase the purchasing power? Perhaps ... but we should remember that this only works if demand responds appropriately. If it does not you might end up, in Japan's case, to push the domestic economy into deflation. Moreover and since Japan is highly dependent on exports to grow this is also a double edged sword since an increasing currency to mitigate terms of trade would also hurt companies' competitiveness; even if many would argue that the current value of the Yen would merit this.
On the specifics of monetary policy Shirakawa notes the reluctance of the BOJ to pre-commit;
"As I have explained, the outlook for economic activity and prices is highly uncertain at present. In this situation, the Bank considers that it is not appropriate to predetermine the direction of future monetary policy. Based on a thorough examination of the economic and price situation as well as the market situation both at home and abroad, the Bank will carefully assess the future outlook for economic activity and prices, closely considering the likelihood of its projections as well as relevant risk factors, and will implement its policies in a flexible manner."
This is basically central bank speak for "on hold" and would be very weary of calling a move either direction throughout the rest of 2008. For the chart hungry the BOJ's June report on the economic development is the place to go. It basically reiterates all the main points touched above. Japan will continue growing albeit at a slower pace which is going to be determined by the extent to which exports will continue to expand. Prices provide a risk but against the sharp backdrop of consumer spending and domestic activity this latter point is where the focus is.
The Perpetual Holding Position?
Anything short of cataclysmic events point towards the BOJ holding rates during the meeting next week. So, isn't this just the easiest job in the world being a BOJ watcher? At the moment it certainly seems to be quite an automatic exercise in terms of the direction of policy; quite simply there does not seem to be one which translates into a solidified holding operation. A couple of events however might wrestle the BOJ out of their current stance; in either direction.
- One would be a return of inflation in core-of-core prices. I have argued (see links above) why I think this is unlikely but given that fact that the US style core index is running at "only" -0.1% it is not impossible to imagine a return to inflation. In such a scenario and given the current focus from investors and international policy makers on inflation it could prompt the BOJ to raise. I think however that it would take something in the region of three month's consecutive positive and increasing reading before such a move be considered.
- Another event which could provide some action is a return of the focus on Japan as the main global liquidity anchor. This would be a return then to the days of 2006 and beginning of 2007 where Japan and its currency were the main talk of the town. If the economic fundamentals continue to deteriorate at the steady pace most analysts expect I have a hard time seeing the BOJ being bullied into raising rates. However, it would serve investors well to remember that what brought the BOJ to 0.5% in the first place was actually the very same pressure from G8 that I am suggesting will return. Edward Hugh's note at the time provides an excellent overview of the situation.
- Finally, we should not dismiss the possibility that things take a turn for the worse and to such an extent that the BOJ be forced to lower rates, perhaps even reintroducing ZIRP. In a world where inflation is perceived the main culprit for the incoming economic ills such a move won't be easily wringed by the BOJ. One thing which could prompt such a scenario is the the solidification of deflation in core-of-core prices. As with the mirror situation described above I think it would take a marked deterioration in domestic inflation and demand dynamics before the BOJ considers this. At this point it is very difficult to gauge where the market discourse goes in the future. One could then easily imagine that fears of growth will return to the market in which case the BOJ's ability to sneak back into ZIRP will be eased.