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.

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).

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.