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Monday, January 13, 2003

Dollar Up, or Dollar Down

So which way is it this year for the greenback? A bevy of commentators (including the IMF and the OECD) regard the dollar as seriously overvalued. In principle I agree. The real problem is to identify a sound substitute. In this piece Morgan Stanley's Stephen Len argues for the dollar downside effect dominating. (Why is their global economic forum so full of talent, is this another example of a networking effect? Nine times out of ten I would certainly back the 'instinctual' economics of Roach's team over their aforementioned more heavyweight institutional rivals). What makes his argument interesting, and out of the pack, is that he justifies this by countering the weak yen view.

The topic of the month is the change of governor at the Bank of Japan (BOJ). There is a kind of will-he, won't-he debate over whether this will mean that the BOJ will go for that flavour of the month: inflation targeting (IT). What Len suggests, and I think this is a good argument, is that whoever is chosen the likelyhood of IT in the near term is extremely small. This is not only due to conservatism and lack of reform spirit at the BOJ, but because they seriously doubt it is credibly attainable on a sustained basis, hence their reluctance to jump for it. Many American commentators suggest that they are wrong (in fact too often they suggest they aren't even trying which is absurd) and that what they need to do is systematically (and in duly non-sterilised fashion) purchase government debt. Len is a Japan finance and in particular a Japan Government Bond (JGB) specialist and he strongly doubts this would work. The only clear strategy for provoking inflation he argues is by the BOJ purchasing foreign securities, and this they are still far from ready to do (again with reasons which could be argued). Maybe by the time they get round to doing it Bernanke will be leading the Fed into acquiring JGB's so they could do a straight swap. Bottom line: this year it's more probable that the dollars tendency to go down will dominate, but in currency markets sometimes anything can happen! Since I have long held that monetary factors only give part of the story for the thirtees depression, and that beggar-thy-neighbour devaluations and protectionism (especially in the case of labour mobility) also have their part to tell, I can only view all of this with growing concern. When will we get round to discussing the real problem, in the real economy? Meantime watch out Euroland, up you go.

The term of the current Governor of the Bank of Japan (BOJ) ends on March 19. From recent official statements, there is strong support within Koizumi’s government to replace Governor Hayami with someone who is sympathetic to the idea of inflation targeting (IT). If such a candidate is indeed appointed as the next BOJ Governor, the currency market’s initial knee-jerk reaction is likely to be a modest rise in USD/JPY -- modest because the market has already priced in a high probability of this outcome. (Conversely, if it turns out that the new Governor is not a strong supporter of IT, USD/JPY could fall!) However, whether USD/JPY rises further and stays high, against what I expect to be a broad downtrend in the USD this year, depends on a number of considerations. One key point in this note is that, for USD/JPY, the instrument that the BOJ uses to achieve an explicit inflation target is more important than whether there is an inflation target. Only if the BOJ decides to buy large quantities of foreign bonds would USD/JPY rise over the medium-term, in my view. In all other cases, I believe that any rise in USD/JPY will be temporary and psychological, and will eventually be overwhelmed by economic reality, which, in my view, justifies a lower USD/JPY.

The most compelling argument against the BOJ adopting an inflation target is that such a policy objective lacks credibility because it is simply not achievable under the current circumstances. Japan is suffering from "real deflation", not "monetary deflation". Money printing alone cannot get Japan out of this liquidity trap. Having been implicitly targeting an inflation rate of at least zero, the BOJ has already failed at achieving this target. Adding a time frame and making this target explicit would actually hurt the Bank’s credibility, in my view. Further, what if inflation does rise during this period? Should the BOJ tighten to keep inflation contained, given the likely continued weakness in the Japanese economy? Clearly, there are both theoretical and practical complications of adopting IT at this point.
Source: Morgan Stanley Global Economic Forum

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