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Friday, November 28, 2008

Japan Deflation Risk Grows As Industrial Output Falls Sharply

Japanese industrial output was down again sharply in October as manufacturers forcecast further record falls in the months to come, leading to warnings that Japan’s recession may well be much deeper and even longer than originally anticipated. This rather bleak news on Japanese factory output may also be a pointer to a longer and deeper global recession, as Japan's main customers - the euro zone and U.S. - enter recession while growth slows sharply in China.

Industrial output fell 3.1 percent in October, significantly above the median market forecast for a 2.5 percent drop, and the outlook now is for a record 8.6 percent contraction in the fourth quarter. Industrial output has already fallen in all three quarters so far this year and, with exports and household spending now also in decline, it looks very much like the present recession can be a long and deep one, possibly the longest since Japan's two decade low-growth/price-deflation agony started in the early 1990s.

It now looks reasonably likely that Japan’s recession will run for at least two more quarters (until Q1 of 2009) which would make for a full year of consecutive contraction - if realised this will be Japan’s longest running recession on record. Obviously having the yen running close to 13-year highs against the dollar - around 95 to the dollar at the time of writing - isn't helping as it means either tighter margins or lost sales for exporters who earn their income in other currencies.

Japanese employers certainly seem to be readying for a long recession, and only last Friday announced plans to fire more than 30,000 temporary and part-time workers before the end of the business year as the recession deepens. Companies will lay off at least 30,067 non-permanent workers in the six months to March 31 (of these some 19,500 will be temporary workers in the manufacturing sector), according to a survey released by the Labor Ministry. These lay-offs would seem to be the logical consequence of the fact that Japanese manufacturers reported they were preparing the sharpest production cuts in at least 35 years - according METI's monthly industrial production report Japanese companies plan to reduce output 6.4 percent in November, the most pessimistic outlook since the survey began in 1973, and they are looking to follow this with a further 2.9 percent reduction in December, according to the Trade Ministry which consequently lowered its production assessment, openly taking the view that it is now on a “downward trend.”

Deflation Fears Rising

Japanese core annual inflation slowed in October for a second straight month, fuelling concern that the sharp negative energy price shock heightens the risk of a return to deflation as we enter 2009. The core consumer index - which excludes volatile prices of fresh fruit, vegetables and seafood but includes the cost of oil products that are falling rapidly in price - rose 1.9 percent in October from a year earlier, slipping back from the 2.3 percent increase in September. Annual inflation excluding oil products dipped to 1.2 percent while Tokyo figures for November point to further falls in inflation.

If we look at what is known as the "core-core" index (which strips out both energy and fresh food) then we can see that it is far from clear that Japan ever really escaped from the deflation trap, since this reading has been completely flatlining around (and normally slighly below) zero over the last twelve months, and with a very large capacity overhang now developing, this index will almost certainly get back into negative territory very, very soon.

Bank of Japan Governor Masaaki Shirakawa however seems to downplay this issue, since he said last week that while he was aware of the risk the central bank forecast at this point is not registering a return to deflation. As a result there is no immediate likelihood of a return to ZIRP.The Bank of Japan currently forecasts core consumer inflation of 1.6 percent in the fiscal year to next March 31, followed by zero price growth in the following year, but these numbers are almost certainly going to be revised downwards.

Masaaki Shirakawa's rather complacent view of the deflation threat is not held on this blog, nor is it held by a number of other "Japan watchers", among them the OECD, who last week stated that Japan is facing the biggest threat of deflation among industrialized nations next year.

Shirawaka's view is not held by Masamichi Adachi, senior economist at JPMorgan Securities, either, since only last week he wrote in a report that "Japan is getting closer to the status of deflation and the nation's economy will further deteriorate without doubt." I can only wholeheartedly agree. It would be nice if policy in Japan could one day get in front of the curve, instead of seemingly remaining bogged-down behind it.

October Retail Sales Fall

The Ministry of Economy, Trade and Industry reported that Japan's retail trade dipped 0.6% year-over-year in October. The reading represented a steeper decline than the 0.3% drop seen in the previous month. Economists expected a 1% decline for the month.

Meanwhile, sales of large retailers fell a seasonally 4.3% from the year-ago period compared to a 3.3% drop in September and the 4.2% decline expected by economists.

Saturday, November 22, 2008

Exports Drop Sharply As Japan Officially Enters Recession

The Japanese cabinet officially recognised this week that Japan's economy has entered its first recession since 2001, following a second quarterly contraction in Q3 2008. Claus Vistesen has already analysed (in this post) the key issues which lie behind the present recession data, and has also, in this post today, attempted to place Japan's renewed deflation alert in a somewhat broader context. Thus I will limit myself here to looking at the basic GDP data, and the export developments which accompany it.

The Recession Becomes Official

Japan's gross domestic product shrank by an annualised 0.4 per cent in the three months to the end of September, following a revised decline of an annualised 3.7 per cent in the second quarter, according to data released by the cabinet office on Monday. It is quite possible that we will now see a third consecutive quarter of contraction in the October - December period, especially if October's export performance (see below) is anything to go by.

Quarter-on-quarter, Japan's economy shrank 0.1 percent, lead by a 1.7 percent drop in capital spending. In fact, as can be seen in the chart below, Japanese investment has now been dropping back steadily since the third quarter of 2007.

Net exports also weighed on growth - subtracting 0.2 percentage point from growth after imports outweighed an increase in shipments abroad. Exports were up 0.7 percent, while imports climbed 1.9 percent as oil surged to a record in July. Consumer spending, on the other hand, increased by 0.3 percent, a much better showing than the one achieved in the second quarter, when consumption declined a quarterly 0.6%. Year on year, household consumption dropped back from 1.7% growth in the first quarter to 0.4% in the second quarter and 0.3% in the third one.

The rapid decline in the Japanese economy’s fortunes has pushed the government of prime minister Taro Aso into introducing a Y5,000bn ($51bn, €40bn) stimulus package, despite the mounting debt of the Japanese government, while the Bank of Japan has been forced to desist for the time being from its monetary "normalisation" programme, and has but the monetary vehicle in reverse gear by once more cutting interest rates -on this occassion for the first time in seven years. The cut - which was by 20 basis points - took BoJ interest rates to 0.30 per cent, meaning that during the longest economic expansion in recent Japanese history the bank was only able to raise rates by 0.5% during the upswing, and we now eagerly await to see what it will be capable of during the downcycle.

In any event neither the fiscal stimulus nor the monetary easing are likely to be of great impact since Japan's economy is export driven and it is the downturn in demand in the US , Europe, China, Russia and elsewhere, and the consequent battering of Japanese exports, which has lead to the recent strong decline in investment and consumption.

Meanwhile the unwinding of the carry trade has pushed the yen up, and the currency has gained some 9.4 per cent vis a vis the dollar since the end of September (see six month chart below), only adding to the difficulties faced by Japanese exporters as their goods become more expensive for overseas buyers.

The Tokyo stock market has also fallen 44 per cent fall this year, depressing consumer sentiment, while bankruptcies in October hit a 2008 peak of 1,429, according to credit reference agency Tokyo Shoko Research.

And we should not imagine that the current recession is likely to be short lived one, since we are going to have to learn to live with the current problems for most of 2009 at least, an outlook which has also been endorsed by Japan's economy minister Kaoru Yosano, who warned last week that the next fiscal year (starting in April 2009) was likely to continue to register negative growth for the economy. "I can hardly be confident that it would be positive," he told a news conference.

Export Pressure Grinding Japan's Economy Down

And the present contraction only looks set to deteriorate in the fourth quarter with Japan posting a Y63.9bn trade deficit in October, reinforcing concerns that falling exports will push the country even deeper into recession. In fact Japan's exports declined at the fastest pace in almost seven years in October as sales of cars and electronics slumped. Exports fell by 7.7 percent from a year earlier, which was the biggest drop since December 2001, according to the Finance Ministry.

The monthly report showed just how the global financial crisis is hurting demand from emerging markets, which up to now have helped prop-up Japan's export growth as shipments to the U.S. and Europe have waned. Not surprisingly - since Europe is in recession - shipments there plunged an annual 17.2 percent, the largest drop since December 2001, while demand from the U.S. dropped 19 percent. But even exports to Asia were down (byan annual 4 percent) while shipments to China fell for the first time in three years.

We should, however, bear in mind, that these figures are to some extent influenced by the yen value of the export shipments, since euro and dollar denominated prices will have registered lower readings when converted back into yen, due to the sharp and sudden rise in the yen in mid October, which could hardly have been anticipated at the time of planning shipments. So yen fluctuations may make the October numbers look worse than they actually are in volume terms.

Imports, on the other hand, were up 7.4 percent on the year, and this produced the trade deficit of 63.9 billion yen ($666 million), the third shortfall so far this year.

Deflation A Large Problem That Once More Looms

Both the U.S. Federal Reserve and Bank of Japan officials now openly admit to being on active alert for the early signs of deflation, and both are actively grappling with the thorny problem of just how to continue to keep it at bay as interest rates steadily approach zero (well, truth be said, in the Japanese case they never moved too far away from it). There are growing signs that the Federal Reserve may have already resorted resorted to some form of quantitative easing - a procedure that relies more on massive liquidity injections into the banking system than it does on the more conventional key policy-rate-driven monetary tools.

But while Bank of Japan Governor Masaaki Shirakawa accepted that just such injections had helped stabilise (but not cure) Japan's decade long deflation problems, he declined to comment on whether or not it would currently be the best response to the economic downturn in Japan.

As Claus indicates in his accompanying post, central bankers who only few months ago were struggling to contain an inflation flare-up stoked by soaring commodity prices are now desperately trying to prevent the global market rout from degenerating into a cycle of falling prices and economic output. Consumer demand is falling sharply across most of the industrialized world and U.S. while consumer prices fell at a record pace in October.

The Fed and other central banks are already flooding the banking system with cash in an attempt to prod banks into lending to each other, but the funds supplied are still lent at a some sort of notional cost (however low). In Japan, during the period of quantitative easing from 2001 to 2006, banks received cash free (although during deflation since prices drop, the value of money paradoxically rises) in the hope that it would spur credit growth and consumption. But the Bank of Japan is being much more cautious at the moment about what the best policy to tackle deflation actually is, and for the moment are relying on interest rates being held at 0.3 percent.

Bank governor Shirakawa said on Friday that in his mind further rate cuts might do more harm than good by further disrupting markets. He was also pretty non-committal about a return to quantitative easing.

"The BOJ decided to implement quantitative easing in the past because it was appropriate to do so in light of economic developments at the time," he said. "As for what would be the best policy in the future, we will decide by examining economic and financial developments."
When asked about the risk of falling prices, Shirakawa said: "Now that raw material costs are falling, a key factor to watch is whether that would cause a knock-on effect and push down overall prices." "We will closely watch the balance of domestic supply and demand and how people's price expectations develop".

However, with Japan's economy already in a recession and oil and commodity prices in sharp retreat, it looks very probable that core core consumer prices will start falling again either in December or early next year, at which point the Bank of Japan will have some serious thinking to do. In the meantime, as always, we watch and wait.

Friday, November 21, 2008

Some Random Thoughts On The Deflation Problem

by Claus Vistesen: Lausanne

Today it is precisely one month ago that yours truly noted that he was swamped. He still is, but even though your author is still struggling to meet the quantitative demands of neo-classical graduate economics (especially, the statistical vintage) he still thinks that now might be as good a time as ever to jump back into the saddle and practice some economic punditry. After all, this is something he, much unlike graduate econ math, is quite familiar with.Needless to say, it is difficult to know where to start but since I am only now returning from an extended pause it might a good idea to pick up one of the themes I laid out just before the anvil of quantitative science hit me. Consequently, one thing that I have been persistently noting in my ongoing analysis of the global economy has been the risk of deflation in key economies due to the dramatic decline in domestic demand and credit momentum.

Specifically, I have been warning that when it comes to the old economies of the world (measured by median age) the risk of a deflationary backdrop is particularly large. The argument here is really quite straight forward in terms of economic dynamics and basically hinges on the idea that relatively old economies do not have sufficiently dynamic internal demand conditions to prevent their economies from falling into deflation. Obviously, the risk of deflation can hardly be confined to these economies at this point and what we are facing now is a potential scenario of global deflation both in terms of core and headline prices as well as of course asset prices. At least I would say without sounding too doomist that this is now a real threat.

Deflation Coming to a CPI Near You?

A couple of months back I sketched my thoughts on the topic as I asked the simple question of whether deflation would be the next macro story. As the carnage in global finance continues and as the effect on the real economy is increasingly making itself felt I am sure most analysts and observers feel a bit shell shocked. I know that I do. Consider consequently the recent news that consumer prices in the US fell a whopping 1% on a monthly basis which more than suggests how the threat of deflation is mounting.

Of course, the monthly decline in consumer prices masks a healthy y-o-y growth rate of some 3.7% (2.2 in core prices) which does not exactly spell deflation in any sense of the word. However, the negative momentum must be considered here and in particular the fact that the global economy has gone from a situation of liquidity disruptions confined to the wholesale banking market, over to a severe credit crunch in terms of firms operational finance and on to what must now be considered a complete freeze of lending to all agents. On the back of the recent barage of execrable news from the US, JPMorgan rolls out the inevitable prediction that the Fed and Bernanke may even introduce some form of ZIRP to counter the recession.

And speaking of ZIRP we learned yesterday from Japan how exports sank the fastest pace in seven years which also prompted analysts from Barclays to suggest that Japan would return to deflation and that the BOJ would have to re-introduce ZIRP accordingly.

I don't know whether the good lads at Barclays had to dig deep to come up with this call; needless to say that deflation in Japan is now a foregone conclusion as we venture towards 2009 and the previous sharp dose of cost push inflation tapers off. At the BOJ, rates were kept at the odd 0.3% yesterday and while there may be an strong inclination not to cut rates to 0% for simple reasons of credibility I do think that they will have to bite the bullet as we move forward into this slump. In a general global context, I think it is important to recognise the massive negative shock we are seeing on demand conditions in those nations who have hitherto been living high on credit and since the credit channels are now firmly broken, so will those macroeconomic credit providers (read: exporters) also suffer .The epitomy of this must clearly be Japan but also Germany comes immediately to mind.

And now that I am talking about Europe, the deflation ghost is also here hovering like a dark shadow over the economic edifice. Of course, and as a hell of a lot more than the proverbial Rome is burning I am not sure what the ECB will do here? It is true that it seems that European policy are content with flexing their fiscal muscles while Trichet et al. remains in the ivory tower where the M3 presumably is still growing above target and where only a definitive drop in consumer prices below 2% would seem to allow the ECB, in a postmortem perspective, to really act along the lines of its other CB peers. At this point I will give the ECB the benefit of the doubt in the sense that we have indeed observed a real change of strategy, but given other CBs' response the ECB seems still, to be the odd man out.

That may change quickly though. The Spanish representation at the ECB roundtable certainly seems to be predicting a dire potential outcome which, given the state of things on the Iberian peninsula, it is difficult to second guess.

European Central Bank council member Miguel Angel Fernandez Ordonez forecast an ``enormous'' drop in euro-region inflation. Bank of Spain forecasts for the 15-nation euro area ``show an enormous moderation in price gains, but they do show price gains,'' Ordonez, who is also governor of the Spanish central bank, told reporters in Madrid today. The forecasts ``don't show deflation,'' he said.

As in the US we are far from an actual state of deflation, but given my argument as I laid it out (see link above) the negative momentum we are observing suggests that what comes next on the macroeconomic front may be quite "unexpected" as those ever incoming stream of Bloomberg headlines are so fond of noting. If we look at the evolution of data the interpretation is quite clear. As can be seen from the graphs below, the decrease in inflation is currently being produced solely as a function of declining headline inflation (this is the same picture as the one emanating from the US and Japan).

More generally, it is hard not to think back to the days when Trichet was playing tough on inflation, when CEE central banks revalued as there was no tomorrow, and where moral hazard (or traitor?) was pinned on all those who had the temerity (I positively love that word!) to argue that something had to be done. Clearly, we are past that now and to steal again the analogy conjured by my colleague Edward Hugh; what is the point in having your throat slit alongside your enemy's just to see who can run the fastest before bleeding out? Clearly, not the most productive of endeavors I would say.

Meanwhile and returning to the graphs one last time it seems as if, once again, one of Macro Man's metaphors will be useful; more specifically I am talking about the one in which Trichet does the humpty dance (now, there is a party I would attend!). Do you see a hump sir? I do.

Obviously it is never so simple. First of all there is the good old sticky price phenomenon which is also present in the graphs where headline (cost-push) inflation is coming down rapidly but where core inflation naturally will need more time before adjusting to the economic fundamentals. In this way, and if we pull out the oldie but goldie dichotomy between the Anglo-Saxon and Continental European economies conventional wisdom would have it that prices (and wages) adjust more more slowly in the latter. In some ways this would merit the divergence between the Fed and the ECB in tackling this mess. However, I am not sure such MD/SAS analyses apply in this case. More specifically, what I am looking for in particular is what will happen in the transition as many economies now will need to depend more on external demand to achieve growth. Remember here that all those rescue packages need to be paid for and domestic demand in itself will hardly do it. For the US et al. a reduction of external imbalances will be of material importance.

Thus, I am also sure that we have the whole rebalancing/global imbalances discourse knocking around somewhere in the background. Yet, I am just not sure that the ECB can "help" the US by keeping interest rates up and by derivative "offering" the Eurozone as a shoulder on which the global economy can lean for demand. Add to this of course that the market has already discounted the incoming recession through the absolute slaughter of the EUR/USD.

In this sense the ECB may get double pinched since if they lower rates further (and one has to assume that they will) it COULD take the Euro to a level where the objectives of policy would be in conflict in the sense that rates would have to be kept higher than otherwise to avoid the Euro to fall in the .9-.8 region. In some ways, this is would square well with the likely growth path of the "future" Eurozone as an economy driven less by domestic demand than has hitherto been the case. And yes, you heard me right, there will be much less domestic demand to go around in the Eurozone and indeed the entire EU 27 once the corrections in Spain and Eastern Europe becomes clear for everybody.

And thus we end up at one of my favorite hobby horses (I have several). In a world where governments are presiding over ageing populations and faced with a major overhang of debt in the context of fighting this behemoth of a financial crisis, the incentive to try to burn up the debt through inflation (and for all things in the world, to avoid deflation) and thus by derivative export your way out of trouble is massive. I would hold this to be true even without the particularity of the current situation in the sense that as the world ages so does the number of economies dependent on external demand grow. In fact, it is precisely this "incentive" to be export driven I think it is so crucial to pin down in both a practical and theoretical sense, but that will have to wait for another day.

Tuesday, November 11, 2008

Japan Machinery Orders Fall As Small Business And Consumer Sentiment Hit Record Lows

Well, the outlook for the coming months in Japan looks none too positive, with machinery orders and small business sentiment both plumming the depths right now.

Japanese machinery orders fell by 10.4 percent in the third quarter, equalling the biggest drop on record, as manufacturers cut their investment plans in anticipation of the impact of the global slowdown on overseas demand. The decline in orders, which is normally read as an indicator of capital spending the next three to six months, broadly equals a drop registered in 1998, the last time the Japanese economy fell into a really serious recesion..

Month on monthly Japanese machinery orders were up 5.5 percent in September, a move which was described by the government as a "weak rebound.''

Economy Watchers Index Hits Lowest Recorded Level

Sentiment among Japanese small businessmen was the worst ever in October according to the lastest reading on the Economy Watchers index, a survey of barbers, taxi drivers and others who deal with consumers,which dropped to 22.6 in October, the lowest since the government started the survey in August 2001.

Consumer Confidence Falls To Record Low

And just to add to all the woes Japan's consumers became the most pessimistic they've been in at least 26 years in October, making it unlikely they will increase spending very much in support of an economy which has already beenweakened by slower global demand and falling stock prices. Japan's consumer confidence index dropped to 29.4 last month from 31.4 in September, according to the latest report from the Cabinet Office, that's the lowest reading since the Japanese government began compiling the figures in 1982.

Among the four index sub components the outlook for wages stood out, since it dropped to the lowest on record. Confidence about employment also slid 4.1 points, the biggest monthly fall since 2004.

Japan's wages grew in nominal terms by only an annual 0.1 percent in September, and in real (price adjusted terms) they fell by 2.2% (the sixth consecutive month of real wage decline). Monthly wages, including overtime and bonuses, rose to 273,175 yen ($2,761) from a year earlier according to the most recent data from the Japanese Labour Ministry.