Steady as She Goes?

(Cross-post from Alpha.Sources)

Thursday has arrived and so has the BOJ's decision to hold as well. In terms of the general market expectations this is quite surprising since most major analysts predicted at the end of 2006 that the BOJ would raise rates in 2007 starting off with a raise in January. This has not been the case and now of course questions are mounting on the real state of the Japanese economy not to mention market observers who are beginning to question the BOJ's independance vis-á-vis policy pressures from the ministry of finance which has been against a rate raise this time around due to the inability of consumer spending and inflation figures to provide support for such a decision.

(from Bloomberg - bold parts are my emphasis)

The Bank of Japan held its benchmark interest rate at 0.25 percent, averting a clash with government officials who say household spending and inflation are too weak to withstand higher borrowing costs.

The decision was split six-to-three, the bank said today in Tokyo, prompting traders to bet on a February increase. Board members were divided over the outlook for consumer spending, Governor Toshihiko Fukui said.

(...)

``The impression that they caved to political pressure is unavoidable,'' said Noriko Hama, professor of economics at Doshisha Business School in Kyoto. ``It's not a bad decision, given the statistics, but it certainly does not look good for the BOJ.''

Moreover, the article also reports how Q4 GDP numbers and general economic data should show a considerable rebound in consumer spending which could allow the BOJ to push rates up in the end of February. I have argued why I don't see this happening but as always we will see. In terms of more coverage of this the FT also has the story.

Over at Morgan Stanley's Global Economic Forum Takehiro Sato actually apologizes to the readers of GEF that he mistakenly predicted a BOJ hike this time around. Sato initially focuses on the political conflict between the BOJ and Abe's administration and also argues that the BOJ perhaps generally lacks the political clout to persuade policy makers that the normalization process is the right way to go.

In our view, the additional rate hike in question was never a ‘must’, but our misreading of the forcefulness of political pressure played a part in our error. It is also probably true that the BoJ, though it shifted to a forward-looking monetary policy following the end of quantitative easing, struggled to persuade politicians with its contentions in the current environment where consumption and prices remain sluggish; the BoJ lacked the track record to push this through.

I won't deny this analysis but this is really a question of the proverbial chicken and egg since we might as well also ask whether in fact the economic data has been supporting the idea of a rate hike at all? However, by reading through Sato's analysis we are also told which kind of fundamentals our expectations should be aligned towards. In short; what is in fact the risk of Japan slipping back into deflation and thus the BOJ slippling back in ZIRP at some point in 2007?

The problem is that even if the bank ploughs ahead with a February rate hike for instance, the outlook thereafter is quite uncertain as prices are expected to remain sluggish. Our official core CPI outlook calls for the baseline to improve by +0.6ppt YoY through January-March 2008, but such high-paced gains are hard to imagine in light of recent weakness. If the baseline fails to improve, the core CPI could revert to negative territory this spring, spurred by falling crude oil prices, and rather than anchor in positive range in F3/08, could even sink below the water level throughout the year. If so, we would be forced to retreat from our present scenario of 0.25% rate hikes every six months. The current hike delay by the BoJ also makes the above less a risk, and more a reality. We plan to issue another report next week to amend our official outlook on the policy rate, based on the bank’s current policy decision.

As I argued with some force recently we really need to look at the general market expectations on Japan here and ask whether these are viable? In the end, investors and analysists just cannot fight the fundamentals by sticking their head in the sand as an austriche.

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.