Faceoff in Japan

(Cross-post from Alpha.Sources)

If you thought in the beginning of this week that a raise by the BOJ come tomorrow was a sure bet you should perhaps think about revising your views. The situation in Japan is a difficult one; ever since the BOJ ended its ZIRP policy back in June 2006 markets have more or less been expecting the transition towards a normalization process where the BOJ would be able to raise the interest gradually to take it off its current very low level of 0.25%. However, the economic data to support such a process has simply not been going the BOJ's way. It is not that Japan has not experienced economic growth but most of it has been driven by exports and this is the main issue here ... even though the BOJ ended ZIRP key economic data such as consumer spending and inflation figures simply have not supported the BOJ to go north.

However, the pressure is mounting on the BOJ to set off this normalization process and until the beginning of this week it was widely expected that the BOJ would raise at least one time in the beginning in 2007. Yet, as domestic political interests now are being mobilized as well as a function of the Japanese ministry of finance the BOJ is really caught between the proverbial rock and hard place.

(from Bloomberg - bold parts are my emphasis)

The Bank of Japan faces a test of its credibility tomorrow after local media said policy makers will delay raising interest rates, spurring concern they are bowing to government pressure.

Bonds rose the most in almost four months and the yen fell to a 13-month low after Kyodo News, the Nikkei newspaper and NHK Television said the central bank will likely keep its benchmark rate at 0.25 percent. Ruling Liberal Democratic Party Secretary General Hidenao Nakagawa said on Jan. 14 that the government should request a policy decision delay.

Governor Toshihiko Fukui risks appearing to yield to political opposition, hampering his plan for gradual rate increases to head off a repeat of the 1980s asset bubble that triggered a decade of stagnation. The government is concerned that a rise in borrowing costs would exacerbate a slump in consumer spending.

``This is a shame and disgraceful,'' said Tomoko Fujii, senior economist at Bank of America N.A. in Tokyo. ``Can't they trust their own central bank? This kind of thing never happens in the U.S. and Europe.''

(...)

Japan's households became the most pessimistic they've been in a more than year in December after wages fell, the Cabinet Office said today. The report signaled consumer spending may be slow to rebound after declining at the fastest pace since 1997 in the third quarter.

The FT also has the story and highlights the strenuous relationship between the BOJ and the domestic political scene.

The Bank of Japan began a two-day policy board meeting Wednesday amid intense political pressure not to raise interest rates.

In recent days, bank officials have, through speeches and background comments, prepared markets for a possible rise in the overnight call rate from 0.25 per cent to 0.5 per cent. That has elicited a strong counter-offensive from the administration of Shinzo Abe, prime minister, which says it is premature to raise rates before Japan has definitively escaped from deflation.

(...)

Local media quoted unnamed sources Wednesday suggesting the BoJ might be willing to hold off raising rates. The bank is in a blackout period and strictly forbidden from making any comment.

Overnight swap futures immediately reacted, suggesting there was a 40 per cent chance of a rate rise Thursday against the 80 per cent likelihood they were factoring in a few days ago. The benchmark 10-year Japanese government bond rose, pushing the yield down 6bp to 1.675 per cent. The yen weakened to a 13-month low of Y120.80 against the dollar.

Jesper Koll, economist at Merrill Lynch, said: “This is a blackout period. The BoJ should launch an investigation into how this got out.” He added: “If the BoJ doesn’t raise rates [Thursday], they’ve clearly caved in to political pressure and have given control [of monetary policy] to the politicians. They have lost control of the debate.”

Of course this is a lot about communications and essentially how the BOJ is in fact and most definitely caught between a rock and a hard place. We all want and need to see a raise but what if expectations are just off here? I mean, would it be so hard just to state the obvious here and look at the fundamentals which simply don't merit a raise at this point. Moreover, we need to ask ourselves what really is the key to the Japanese economy at this point and then I believe we could begin to let expectations correct to the much allured fundamentals. Lastly, I want to point you to the aggregate blog of me and Edward Hugh's posts on Japan which pretty much has been predicting this a year now; so expectations have not been off all over the board it would seem.

Japan in a Quandry

To raise or not to raise, that is the question, for the BoJ at least. This seems to be just one more between a rock and a hard place situation. According to Bloomberg:

The Bank of Japan may raise its benchmark lending rate from 0.25 percent, stepping up efforts to head off an investment bubble.

The reason for the fear is not a sudden and excessive rise in consumer related activity (like construction) but a rapid build up in investment (which means more capacity, capacity for which the demand may be lacking in sufficient quantity):

Large companies plan to increase investment in the year ending March 31 by the fastest pace since 1991, the central bank's quarterly business survey showed in December.

``Short-term interest rates are exceptionally low in Japan, in particular against the backdrop of the much improved structural situation of the economy,'' said Jan Lambregts, head of Asian research at Rabobank International in Hong Kong.

Now it is important to keep in mind here that Japan's recent growth spurt is largely driven by export demand, and the investment activity needed to sustain this dynamic. Domestic consumption still remains extraordinarily weak (and the reason for this may well be the age structure of Japan's population, as I attempt to argue here):

Some economists said the bank may postpone a rate increase until February so that it can confirm a revival in consumer spending when the government releases its gross domestic product statistics in mid-February. The 0.9 percent drop in consumer spending was the main drag on growth in the third quarter.

Now obviously containing animal spirits on the investment side is important, but what of the impact of any coming rate hike on domestic consumption, the deflation issue, and of course the costs of servicing Japan's enormous public debt?

A one-percentage-point gain in the yield on Japan's benchmark 10-year bond would increase the country's debt-servicing costs by about 1.6 trillion yen next fiscal year, the finance ministry estimated in December.

The deflation isssue should not be treated lightly, in particular since, as MS's Takehiro Sato pointed out last Friday:

Fundamentals are favorable, but there are a number of headaches for policy makers. Since oil prices are dropping faster than expected, the possibility of a drop into negative territory for the CPI is moving beyond just a risk and becoming the main scenario.

All in all, confrontation may well be looming, between the Japanese government and the BoJ, and if it is not very careful the bank may gain short term advantage by damping down excess investment only at the price of provoking a return to deflation and a loss of its credibility and independence in the longer term.

Machine Orders Reinforce a Hike by the BOJ ...

(Cross-post from Alpha.Sources)

or do they? If you ask the investors, of which most admittedly live in a quite different short term world than myself, a firm 76% according to Bloomberg believe that the BOJ will raise the rate this Thursday which will bring the rate up to 0.50% from the current 0.25% as it has been held ever since the BOJ ended ZIRP back in June 2006.

(From Bloomberg linked above)

The yen gained for a second day against the dollar after a report showed accelerating growth in machinery orders, boosting the Bank of Japan's case for raising interest rates.

Investors see a 76 percent chance the BOJ will increase borrowing costs this week, up from 66 percent on Jan. 12, according to Credit Suisse Group calculations. Rising rates may encourage Japanese investors to keep money at home and will make raising funds in yen to buy higher-yielding assets more expensive.

``Traders took a good look at the machinery orders data and are buying yen,'' said Osao Iizuka, head of foreign-exchange trading at Sumitomo Trust & Banking Co. in Tokyo. ``The numbers support speculation the BOJ will raise rates this week.''

My discourse on Japan should not be seen in a week to week perspective but in more long term perspective. As such, I think that we need to ask ourselves what an increase in machine orders mean at this stage and whether this increase in machine orders is driven by domestic or foreign demand? This is a very important question since one of the most vexing questions concerning the Japanese economy at the moment is the relationship and transmission dynamics between the corporate sector which exhibits strong momentum (i.e. the numbers today) and a domestic economy which does not seem to respond to the buyoant corporate and as such consumption and inflation continue to remain very low. What happens if the BOJ raises on the back of these perky business sentiments if the transimission mechanism is somewhat broken between the domestic economy and a highly competitive and efficient export sector.

To Raise or not to Raise ...

(Cross-post from Alpha.Sources)

This still seems to be the most vexing question concerning the Japanese economy at the moment. In terms of economic data going out of 2006 the news flow has been anything but positive thus raising serious question about the BOJ's strategy of returning to normal or at least moving further away from its quantitative easing policy operationalized as ZIRP which was formally ended in June 2006 as the BOJ raised to 0.25%. As I said the data from Q3 and (most likely) Q4 is not positive (Bloomberg).

Japan's broadest index of future economic activity dropped in November, indicating that growth in the world's second-largest economy may slow.

The leading index, which comprises measures such as machinery orders and consumer confidence, fell to 20 percent from 54.5 percent in October, the Cabinet Office said today in Tokyo. The result matched the median estimate of 26 economists surveyed by Bloomberg News. A number below 50 indicates the economy will cool in three to six months.

Japan's economy grew at the slowest pace in almost two years in the third quarter of last year after the biggest slump in spending by consumers in about a decade offset an expansion in business investment. Some economists expect the nation's corporate growth to eventually flow through to consumers.

(...)

Bank of Japan Governor Toshihiko Fukui cited weak consumer spending as a reason for keeping the lowest interest rates among industrial nations unchanged in December and the central bank downgraded its assessment of household spending in its monthly report. The bank ends a two-day meeting to decide the level of interest rates on Jan. 18.

Still, we the recent hints from BOJ governor Fukui are not decisive in term of predicting a policy at the meeting next week. However, the Bloomberg piece cited below still seems to narrate the situation as a likely raise next week on the expectations of rising inflation and hmm consumer spending on an 'expansiory' path. Don't bet it all here I would say.

Bank of Japan Governor Toshihiko Fukui reiterated that policy makers will examine economic data and act accordingly, offering few clues about whether they'll raise interest rates next week.

``We are committed to supporting sustainable economic growth by closely examining data and implementing policy appropriately,'' Fukui said at a quarterly meeting of the Bank of Japan's regional branch managers in Tokyo today.

(...)

``The governor intentionally refrained from dropping any signals about next week's rate decision to avoid shaking up financial markets,'' said Hiroaki Muto, a senior economist at Sumitomo Mitsui Asset Management in Tokyo. ``Markets are pretty much factoring in a rate hike, and we bet the central bank will take action next week.'

(...)

The central bank kept its key rate near zero for six years to bring Japan out of deflation before raising it in July to 0.25 percent.

Consumer spending is on an ``expansionary path'' although its pace of growth has been modest, Fukui said. ``It is highly likely that the expansion of the Japanese economy will be sustained.'' He said core consumer prices, which exclude fresh food and are the bank's key gauge of inflation, will keep rising.

It will ve very interesting to see what the BOJ has in store for us come next week.