Kazumasa Iwata: the Current State of the Japanese Economy

by Claus Vistesen

have been pretty preoccupied as of late with Japan and as such I thought I would also share with you a recent speech by Deputy governor of the Bank of Japan Kazumasa Iwata on the immediate outlook of the Japanese economy and monetary policy. As you can see he is much more optimistic on the rebound of inflation and consumer spending than I am. Moreover the speech also gives a valuable insight into the policy setting process within the BOJ. Here is an excerpt from mr. Iwata's remarks on consumer prices ...

The year-on-year rate of change in the CPI (excluding fresh food) was flat in January, and depending on developments in crude oil prices and foreign exchange rates, it may turn slightly negative in the short term. From a longer-term perspective, however, consumer prices are expected, over time, to display trend increases given that the economy has expanded at an annual rate of around 2 percent over the last four years and that the expansion is expected to be long-lasting. With the continuing economic expansion, the utilization rates of production capacity and of labor have been rising steadily, and they are expected to increase further. As the recent Tankan (Short-Term Economic Survey of Enterprises in Japan) indicates, corporate managers are increasingly feeling shortages of production capacity and labor, while a positive output gap suggests that demand currently exceeds supply in the economy as a whole.

Note, especially the idea of a positive output gap and how demand exceeds supply in the economy. Methinks that someone is not taking into account the nature of Japanese growth and the relationship between domestic capex and foreign capacity. In short; how do we measure output gaps adequately in an ageing economy such as Japan's or more specifically ... how does ageing affects the operationalization of output gaps? In terms of output gaps Mark Thoma recently pointed to an article from the Dallas Fed by Mark A. Wynne and Genevieve R. Solomon. The article is an excellent intro to the economic operationalization and measurement of output gaps. Of course I have my mandatory adjustments in order to better take into account the fundamentals of ageing but all in all still a very readable article.

Following Up on Japan

by Claus Vistesen

A week ago I had a note on the economic outlook on Japan and now, with the recent data, I think it is time to do a whee round up. First of all, the chance (or risk) for an additional hike by the BOJ seems to have dissipated with the recent inflation data showing a -0.1% (overall consumer prices -0.2%) y-o-y drop in February on the back of a steady (0%) inflation rate in January. The decline was of course widely expected due to the y-o-y deflationary impact from falling energy prices but still it comes at a bad time for the BOJ after having pushed a rate on the basis of Q4 06 GDP figures and general international pressure to normalize interest rates and thus curb the carry trade. Moreover the preliminary data for March also suggest that prices declined -0.1% in. On a brighter spot industrial production 'only' declined 0.2% in February which suggests that Japanese companies won't sustain de-stocking from Q4 06 too much into March and perhaps capex will begin ticking up already in March which again depends on the fundamentals in Japan's major export markets.

On a much more positive note household spending increased 1.3% on a year earlier in February which indeed is good news as this figure is a key indicator for the sustainability and trajectory of the Japanese economy. Moreover, retail sales also showed slight positive signs although they were virtually flat y-o-y.

So, both good and bad news then but does it change anything from what I said in my last note? Firstly, let us look a bit closer on the outlook for inflation where the always excellent Takehiro Sato serves up the cold facts in a recent note over at MS GEF. The first thing to note is that deflation measured by the core index almost certainly will linger into March as I also noted above but more importantly Sato rolls out an argument and calculations which suggest that deflation will persist on a y-o-y basis much further into 2007 which effectively will stall the normalization process at 0.5%. As such, Sato notes the much pessimistic forecast of a 0.3% drop in the CPI index in Q1 2007 which may even be on the upside. In short, this smells rasther nastily of entrenched deflation in the first two quarters of 2007 save for a major hike in energy prices which are after all trending upwards at the moment. Secondly, we have private consumption and retail sales which show promising signs of a y-o-y improvement in Q1 but what about the fundamentals and the looming entrenchment of deflation? Most notably, the recent Tankan Survey (sorry, no link) also shows that consumer expectations of price increases have fallen back considerably which indicates that consumers probably will hold back spending. This is of course difficult to say and indeed the immediate outlook on demographics reveal that a lot retirees will be up for bonuses soon which means that consumer spending as a function of dissavings might be a trend to look out for but at the end of the if deflation sets in with its nasty grip the fundamentals will indeed be tested. Of course monetary policy is the last part of the equation and here I really do not think we should expect much of a hike although of course the G-7 ministers are still wandering around in wonderland poised to strike once again on the low Yen and the need for the BOJ to normalize.

In summary, I think that the recent signs from the internal demand side proxied by household spending are positive but I am truly worried and not at all happy about the outlook on in(de)flation which I fear will feed strongly into expectations and thus also consumer spending in Q2 2007.

Standing Fast

by Claus Vistesen

Hardly any economist or analyst battered an eyelid when the BOJ chose yesterday to hold the main interest rate at 0.5%. Indeed much of the recent data coming out Japan (and here) recently point to considerable risk of Japan slipping into deflation in 2007 and on that note most economists (including yours truly) expect the BOJ to be in a holding mode for the time being especially as the US economy is to slow down further into 2007.

(from Bloomberg)

Japan's central bank kept interest rates unchanged as consumer prices threaten to drop, making it hard to justify a second consecutive increase.

Governor Toshihiko Fukui and his policy board voted unanimously to keep the key overnight lending rate at 0.5 percent, the lowest among major economies, the Bank of Japan said in a statement today in Tokyo. The bank doubled the rate last month.

``The Bank of Japan probably wants to monitor the effect of the February rate hike,'' said Mamoru Yamazaki, chief Japan economist at RBS Securities Japan Ltd. in Tokyo.

Political pressure ahead of an election in July will also make it difficult for the bank to tighten credit until the last quarter of 2007, Yamazaki said. Business confidence in Japan probably fell from the highest in two years amid concern the U.S. economy may slow, the bank's Tankan survey may show next month.

The yen traded at 117.92 per dollar at 5:44 p.m. in Tokyo compared with 117.87 before the announcement. The yield on Japan's 10-year bond fell 1.5 basis points to 1.56 percent.

Today's decision was predicted by all 49 economists surveyed by Bloomberg News. Fukui said after last month's meeting that the board has no plans to raise rates consecutively.

The governor later told reporters that the U.S. economy remains likely to expand gradually, even after weak data raised concern that growth in Japan's largest export market may slow.

(...)

Reports may show Japan's core consumer prices dropped in February or March because of cheaper oil, Fukui said. Core prices, which exclude fresh food and are a key gauge of inflation in Japan, failed to rise in January after climbing 0.1 percent year- on-year in December.

Fukui said the drop in core prices wouldn't necessarily be bad because lower oil costs help economic growth. Core prices will stay on an expansionary path in the long term, he added.

Kazumasa Iwata, one of the bank's two deputy governors, said at the meeting that the policy makers should explain their outlook for consumer prices more clearly, according to Fukui. Iwata was the sole dissenter to last month's rate increase.

As always, Morgan Stanley's Japan watchers are also following the situation closely and the recent comment from Takehiro Sato as a preview of the Tankan business confindence survey which then failed to come through according to Mr. Sato's expectations of an increase relative to December. In fact, the survey showed that business confidence dropped albeit ever so slightly from the December figures.

Please Take Note

by Claus Vistesen

My regular postings and data watching from the Eurozone and Japan have been somewhat absent as of late. However, I am going to take it up again now and I will begin with Japan. There are many aspects here and one of them is of course the recent rate hike in the overnight lending rate from 0.25% to 0.50% where Edward so eloquently reminded us to look to the past in order to adequately analyze the situation and crucially Edward also voiced his criticism towards those who are so fast and sure in their of the sustainable Japanese recovery. Now, let me put this into some kind of time frame, the recent hike came at the end of February and on the back of positive 4th quarter GDP figures as well as of course the worry about carry trade and the subsequent international pressure on the BOJ. So was the BOJ rate hike in February a sound move based on economic fundamentals? Let us begin with with the Japanese industrial production which slipped 1.5% in January as well as Japanese retail sales which continued their secular decline posting a 0.8% decline as well in January. Adding to all this, Japanese inflation turned to zero in January.

(from Bloomberg - bold parts are my emphasis)

Japan had zero inflation in January, underscoring the nation's struggle to overcome seven years of slumping prices.

Core consumer prices, which exclude fresh food, were unchanged from a year earlier, the statistics bureau said today in Tokyo, matching the median estimate of 39 economists. It's the first time prices failed to rise since May, and followed a 0.1 percent gain in December.

Wages fell the most in more than two years, a separate report showed, damping prospects for faster inflation and higher interest rates in the world's second-largest economy. The Bank of Japan raised rates for the second time in six years last week and Governor Toshihiko Fukui said further increases will be gradual.

``The Bank of Japan isn't going to be able to raise rates as long as CPI is negative,'' said Hiroaki Muto, a senior economist at Sumitomo Mitsui Asset Management in Tokyo, who expects prices to drop next month. ``We're not going to see inflation pick up unless we see wages start to rise.''

So please take note ...

Take note that all the data cited above are from before the BOJ hike in February which of course does not at all bode well for Japan's so-called sustainable recovery and retreat from deflation. Methinks that Takehiro Sato from MS is probably and sadly going to be right on cue on his deflation call for February-March. Also take note that the paradox (excellently described by Dave Altig) in terms of how the recent hike actually caused a depreciation of the Yen may now revert to the opposite as investors seem to have become struck by a recent bug of risk aversion as markets have become rather volatile in the recent days. This has subsequently caused a flight to safe havens by investors and the Yen, sadly for Japan in this case, represents such a safe haven.

(from the FT - hat tip EuroIntelligence)

The Japanese currency has strengthened as recent volatility in global markets prompted a flight to quality that has put pressure on carry trades, in which long positions in high-yielding assets are funded by selling low-yielding currencies such as the yen.

So take note, an appreciating Yen is perhaps at this point driven by short term volatility and as markets stabilize (if and when of course they do) the carry trade might resume its merry way. However, as we keep the January inflation figures fresh in mind as well as the dampening effect of the February hike itself might begin to materialize, the deflationary push related to an appreciating currency is, quite frankly, not what Japan needs in these months with the CPI index seriously flirting with negative territory.

Finally, please take note that although I worry/think about excess liquidity and subsequent excess risk taking as much as the next man pressuring the BOJ to raise rates is not a conceivable way forward from this point. We need to understand why real global interest rates are as low as they and why liquidity and inflation do not seem parallel results of this low interest rate environment. Not until we get to grips with this apparent conundrum can we begin to apply the right tools to adjust the valves of the global econom.

Update on Saturday, March 3, 2007 at 11:15PM by CV

More info on the apparent 'unwind' of the carry trade. I am sure this is only going to temporary in the sense that the fundamentals won't change. However, I do feel that this short term appreciation of the Yen is not welcome in Japan as it is associated with deflation.

(from Bloomberg - linked above)

The yen strengthened the most against the dollar in almost 15 months this week as falling stock markets prompted investors to unwind trades they had financed by borrowing the Japanese currency.

Investors exited the so-called carry trade as they cut their appetite for riskier assets in emerging markets and moved into U.S. government debt. Investors have taken advantage of the lowest interest rate among major economies in Japan to borrow yen and buy higher-yielding assets elsewhere.

``Traders continued to liquidate their carry trade positions,'' said John McCarthy, director of currency trading at ING Financial Markets LLC in New York. ``The yen is the market leader now, and other currencies are under pressure.''

Japan's currency gained 3.7 percent this week, the biggest increase since the period ended Dec. 16, 2005, to 116.80 per dollar yesterday, from 121.08 on Feb. 23. It reached 116.43 yesterday, the highest since Dec. 11. The yen rose 3.5 percent to 154.10 per euro from 159.38 at the end of last week. The 13- nation currency has fallen from a record 159.65 yen on Feb. 23.

(...)

``The move we've seen has nothing to do with the economic fundamentals,'' said Lara Rhame, a senior currency strategist at Credit Suisse Group in New York. ``It's the animal spirit of the market. We will probably see more unwinding of yen carry trade in the short term.''

Swiss Franc

Hiroshi Watanabe, Japan's top currency official, said on March 1 that he sees only ``limited'' effects from the unwinding of carry trades.

The Swiss franc, another currency that is used to fund carry trades, posted a fifth weekly gain versus the dollar. It traded at 1.2165 against the U.S. currency yesterday, from 1.2326 a week ago.

Lehman Brothers Holdings Inc. is recommending clients buy the Swiss currency versus the U.S. and Australian dollars. Lehman, the fourth-largest securities firm, is also telling investors to remain short in the South African rand. A short position is a bet against a currency.

Yen gains may be limited on speculation the carry trade will recover as investors regain confidence in riskier assets.

``There are really few reasons to extend the yen rally,'' said David Watt, senior currency strategist at RBC Capital Markets Inc. in Toronto, a unit of Canada's biggest bank by assets. ``The economic backdrop of the carry trade hasn't changed. Japan still has low interest rates.''