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Wednesday, November 15, 2006

The Japanese Yen

One of the important features of the current Japanese export driven 'recovery' is the relatively low (indeed vis-a-vis the euro historically low) value of the yen. Surprisingly few commentators have seen fit to comment on this, or on the significance it might have for the debate about whether or not Japan is finally escaping the deflation problem. In the days when people still used to talk about this issue, there was one proposal on the table (principally advocated by Swedish economist Lars Svensson) known as the 'foolproof path' (Professor Svensson's homepage is here, and it contains a whole slew of papers related to this topic).

The foolproof way is to announce (1) an upward-sloping price-level target path to be achieved, (2) a depreciation and a temporary peg of the yen, and (3) the future abandonment of the peg in favor of inflation targeting when the price-level target path has been reached. Then, the BOJ and the MOF just have to behave accordingly.

Now it can easily be seen that a key component of this 'foolproof way' is a substantial depreciation in the value of the yen, and this is what we have seen across 2006. Surprisingly however, and despite the low yen values and extremely high energy costs, Japanese inflation has yet to poke its head above the 1% mark, and with falling energy prices and a slowing global economy is now more than likely (IMHO) headed back into negative - and hence deflationary - territory.

Now one of the important details about the current low values of the yen is that it is in part driven by an outflow of funds from the Japanese themselves:

The yen weakened against the dollar and euro on speculation Japanese investors are seeking the extra yield of U.S. and European assets.

Japan's currency was near a record low against the euro as a government report today showed demand for services in the world's second largest economy fell twice as much as expected in September. The Bank of Japan started a two-day policy meeting today, with economists saying interest rates will stay at 0.25 percent, the lowest among the world's major economies.

``People are looking to the BOJ meeting for more clues on the rate hike outlook,'' said Niels From, a currency strategist in Frankfurt at Dresdner Kleinwort, ``You're still getting big returns from investing in higher-yielding currencies, and the yen should continue to suffer against the euro.''

Now Morgan Stanley's Stephen Yen (who Brad Setser apparently doesn't like at all) had an interesting post about this situation on the MS GEF last week (what Jen calls retail flows are in fact movements of funds by individual investors):

"The accelerated decline in the 'home bias' for mutual funds and retail investors is worth a closer examination. While there is still no definitive explanation of this trend, there is a possibility that it may not be the case that the individual investors' 'home bias' is genuinely lower, but rather that there is just more capital controlled by individuals and therefore more to invest overseas."

"Something that happened 60 years ago may be one contributing factor behind the general weakness in the JPY. During 1946-1949, Japan experienced a mini baby boom. Though it was milder and shorter-lived than the US baby boom (from 1947 to 1964), it nevertheless created a big enough demographic bulge to have consequences now. Relative to a long-term average of around 1.2 million a year in the 'natural' rate of population (birth rate minus death rate), during these four years, the bulge in the demographic profile was close to 2 million, i.e., there was a net 2 million increase in population during this period — an average of 500,000 a year."

"Sixty years later, in 2006, the first wave of these baby boomers reached retirement age. When they received their cash retirement payments, they may have allocated a greater portion of their assets overseas than in previous generations. This may have helped propel an accelerated decline in the collective 'home bias' of mutual funds and retail investment."

Now this is fairly interesting since Jen attempts to link this behavioural change away from home bias to some features of Japan's changing demographics, and in particular to the need (in the uncertain climate of Japan's ongoing problem in funding its pensions liabilities) of finding added yield to cushion any future problems.

Now takes on a lot more interest when you start to think about the fact that a lot of the recent rise in the Japanese stock market was driven by capital inflows - from people with oil surpluses, things like that - on the expectation that the 'recovery' was finally coming. OTOH Jen seems to be indicating that the individual Japanese (institutionally the Japanese will of course always have home bias, which is why you shouldn't expect 'melt down' any time soon, this is one of the big differences between Japan and Italy, IMHO) are sending their money to where they can get higher returns, and in particular the US.

My guess is that people like Brad Setser and Nouriel (and even the likes of Martin Wolfe) with all their dollar-melt-down orientation are completely missing this. So what happens when it becomes obvious that the recovery in Japan isn't sustainable and the BoJ has to back down and re-introduce ZIRP. Well a lot of the foreign money goes out, that's what happens. And the 'retail' flows (as Jen calls individual investors) will keep heading for New York etc. So we are really talking about the Yen potentially holding to very low values (and of course never forget that the renminbi is to some extent weighted to this).

The US Slowdown Contd.

There is more evidence that the US economy is holding to its slower rate of economic growth and that the housing weakness continues:

Home Depot said weakening in the US housing market had come "faster and deeper" than expected and warned that the slowdown would continue next year.

Bob Nardelli, chief executive, said softening in the housing market had caused "significant" deterioration in home improvement sales, with conditions likely to worsen further.

"I would say we haven't, within the home improvement part of this business, seen the bottom yet and I do not see anything that says it's going to get significantly better in 2007," he told investors.

The comments came as America's second-largest retailer announced a 3 per cent drop in third-quarter net profits and lowered its full-year earnings guidance.

Mr?Nardelli?said?a slump in new home construction had reduced sales to builders and tradesmen, while stagnating house prices were deterring consumers from investing in "big ticket" items such as kitchens and carpets.

The FT has a further article in a similar vein:

The latest US retail sales figures, from October, showed that consumer spending remained resilient in spite of the pressures from the housing market. Sales excluding petrol increased by 0.4 per cent over the month. Lower oil prices meant the value of total retail spending fell 0.2 per cent on the previous month.

But downward revisions to the previous two months' retail sales suggested that consumer spending was weaker than thought.

Drew Matus, a senior economist at Lehman Brothers, said: "The retail picture points to a slightly lower growth profile than we anticipated."

The key point would seem to be that retail sales are not benefiting from the reduction in gasoline prices to anything like the extent that some had hoped. Another warning signal came from yesterday's producer price index:

U.S. producer prices took their sharpest tumble in October since a matching record drop five years ago, influenced by cheaper energy that also sapped retail sales and showed a softening pace of economic activity.

A Labor Department report on Tuesday said its
Producer Price Index (PPI) that measures prices at the factory and farm level dropped 1.6 percent. It matched a record fall in October 2001 and was three times the decline Wall Street analysts had predicted.

Core producer prices excluding food and energy fell 0.9 percent, the biggest fall since a 1.2 percent decline in August 1993.

Meanwhile, the
Commerce Department said overall retail sales weakened by 0.2 percent in October after a 0.8 percent fall in September. It was partly because consumers were spending less on gasoline but any drop in consumer spending, which fuels two thirds of U.S. economic activity, makes financial markets wary.

"These numbers are the latest indication that the U.S. economy is slowing and that inflation is in fact decelerating," said Mark Meadows, a currency strategist with Tempus Consulting in Washington.

Now at this point I think it is important to stress that the US economy need to grow at a rate of something over 2% (cruising speed) just to maintain price stability. Any sustained period of growth below this level will inevitably put *downward* pressure on prices given the current global environment and events in China (see last post) will only add to this problem. So we might see a very adroit bit of footwork from the Federal reserve in the not too distant future, with market expectations being shifted towards the disinflationary (rather than the inflationary) danger. Lets just hope that this news reaches the ECB in Frankfurt before something seriously problematic happens in Geramny.

China is Slowing

Well the slowdown in the Chinese economy is now becoming more and more evident. I would be watching for the knock-on effects of this in Japan and Germany. The first sign of this impact was the sudden decline in machinery and equipment orders in Japan in September. (Claus Vistesen is following the Japan situation closely):

China's industrial output rose at the slowest pace in almost two years in October, indicating that a government clampdown on investment is succeeding and an export boom may be losing steam.

Production rose 14.7 percent from a year earlier to 760 billion yuan ($96 billion) after gaining 16.1 percent in September, the National Bureau of Statistics said today. That was lower than every forecast of 20 economists surveyed by Bloomberg News.

Output growth has eased since June as Premier Wen Jiabao moved to choke off funding for wasteful investment projects that threaten to leave China with idle plants. A slowdown in exports could help stem a record trade surplus that's flooded the economy with cash and strained relations with the U.S. and Europe.

``Exports have begun to show signs of weakening,'' said Jim Walker, chief economist at CLSA Asia-Pacific Markets in Hong Kong. At the same time, government ``tightening this year clearly has had an impact on parts of the economy.''

October's increase was the smallest since December 2004, adjusting for distortions caused by the Lunar New Year holiday. For the first 10 months combined, output rose 16.9 percent from a year earlier.

Also notice the disinflationary (or even downright deflationary) pressure which is now coming out of China as I indicated late last week. Yesterday's producer prices data in the US (which I am about to post on) is another reflection of this situation. I think we are about to see another 'reading' of the inflation story. China and the US would seem to hold the key to the general growth outlook for 2007.

Tuesday, November 14, 2006

Japanese Third Quarter GDP

Well Japanese GDP maintained its momentum in the third quarter according to the initial data released today:

Japan grew more strongly than expected in the third quarter with strong exports more than offsetting weak domestic consumption to produce annualized growth of 2 per cent......The economy, which grew a revised 1.5 per cent in the second-quarter on an annualized basis, has been expanding for seven straight quarters. Next week, the recovery will enter the record books as the longest - though far from the fastest - period of sustained growth since the war."

"Third-quarter numbers showed that consumption shrank 0.7 per cent from the previous quarter. But exports climbed 2.7 per cent and capital investment, in spite of weak recent numbers, jumped 2.9 per cent, marking the 10th quarterly rise in a row."

and Bloomberg:

Consumer spending, which accounts for more than half of the economy, fell 0.7 percent, twice as much as the 0.3 percent drop expected, amid a spell of bad weather that kept shoppers at home and as wages growth stalled.

So the picture remains pretty much the same, strong export lead growth sustained by capital investment, with shrinking domestic consumer demand. A big part of the burden was carried by growing investment demand:

"Capital spending in the quarter surged 2.9 percent, more than three times the 0.9 percent gain expected. Mizuho Financial Group Inc., Japan's second-largest bank by market value, and Tokyo Electric Power Co., the nation's biggest power company, announced plans this month to invest as the economy grows."

But the big question mark still remains as to whether this is anticipating internal demand which may not arrive, and whether or not this investment is justified if export demand weakens. In other words we may have excess capacity building up again, which obviously would be deflationary in its impact. This is presumably not being lost on the BoJ who are using the growth in such investment spending as an argument for raising rates, but here, as I have been arguing, they are trapped between a rock and a hard place, and indeed it is hard to assess how many of these investment projects are being financed now precisely to avoid having to pay the higher interest rates which the BoJ is threatening to introduce later.

One thing which is striking here is the way in which, despite the inevitable labour market tightening as the population shrinks, wage drift and inflation remain incredibly tame. This is an indicator of just how far the reform process has actually gone in Japan, since there seems to be absolutely no room whatever for wage-push inflation. This is also something of a warning for those who simply argue that more structural reforms will cure the problem, since in the case of Japan at least they seem to have been tried and found partially wanting. Still, there are those who live in hope:

Koji Omi, finance minister, told the Financial Times last week that the recovery remained solid in spite of signs of slowing US demand. It was true, he said, that higher profits had not fed quickly into better wages and stronger consumer demand. However, he said that, with the labour market tighter than at any time in 15 years, he expected wages and consumption to pick up soon.

Monday, November 13, 2006

Rapid Disinflation???

We will have to wait till tomorrow to know for sure, but there appears to be a quite dramatic rate of disinflation in the US right now:

Declines in the cost of gasoline probably caused U.S. consumer prices to drop for a second month in October, giving Americans extra cash to spend at retailers, according to a survey of economists.

Consumers paid 0.3 percent less for goods and services last month, after prices fell 0.5 percent in September, a Labor Department report Nov. 16 is expected to show. The forecast is the median estimate of economists surveyed by Bloomberg News.

Now we need to follow the course of domestic consumption in order to evaluate the risk that disinflation could turn into outright deflation, something I have always argued was a real and present risk during the downside of this cycle. Certainly the raising cycle is now surely done, and as I have also been saying, the next more in US rates will be down, the only question is when.

Meantime more evidence of disinflationary pressure is coming from China:

Inflation in China, the world's fastest-growing major economy, unexpectedly slowed in October as the cost of food increased at a slower pace.

The consumer price index advanced 1.4 percent from a year earlier after rising 1.5 percent in September, the Beijing-based National Bureau of Statistics said in a statement today. That's less than the 1.6 percent median forecast in a Bloomberg News survey of 16 economists.

Central bank Governor Zhou Xiaochuan, who raised lending rates twice this year partly to slow investment growth, last week said excess manufacturing capacity in some industries is helping contain prices. With a surge in spending on factories and real estate also cooling, the bank may hold off on raising interest rates further until next year.

``If the government does raise interest rates it will be to curb investment rather than because of any worries about inflation,'' said Leslie Khoo, an economist at Forecast Singapore Pte. ``Inflation is likely to remain well behaved.''

Of course, it all depends what you mean by well-behaved in this context. Those (Brad Setser please note) who argue strongly for a sharp rise in the value of the renminbi need to think carefully about what would be the global implications of a Chinese economy which was stuck in some kind of version of a liquidity trap. The present situation may not be an easy one, but some things we could well live without. Sound economics is also about learning to balance comparative risks.

Central Bankers To Eat Humble Pie?

Well, follwoing on from the last post, perhaps it is worth asking just how much longer things can continue like this before the central bankers really have to start eating humble pie, since they have obviously been misreading all of this, and very profoundly so.

We could start with Trichet's declaration of his monetary principles last Thursday:

I have always been impressed by the contribution of my compatriot, Jean Bodin, to our understanding of monetary economics. Drawing on his experience of the inflationary consequences of the influx of precious metals from the Americas into 16th-century Europe, Bodin postulated a direct relationship between the quantity of monetary gold and silver in circulation and the general price level. Thus was born the quantity theory of money, which has survived to this day.

Or has it? Over the next two days, the European Central Bank will host a conference to discuss the role of money in monetary policymaking. At present, the dominant academic view seems to be that monetary aggregates should have no part in monetary policy decisions. From this perspective, money does not deserve to be central to one of the two “pillars” of the ECB’s monetary policy strategy. I do not share this view. In this I follow Friedrich Hayek, who wrote in The Pure Theory of Capital: “It is self-contradictory to discuss a process [inflation] which could not take place without money and at the same time to assume that money is absent or has no effect.”

So we are in the hands of a wanna-be Jean Bodin: hardly an appetising prospect. Of course the key point would be that no-one I have heard of has been arguing that monetary aggregates play *no part* in monetary policy, but just that they are not as reliable an indicator as Trichet seems to imagine. So if you start of by knocking down a straw man, and in addition fail to notice what the real problem you are trying to address relates to (ageing societies and global savings gluts) then it will hardly be surprising if at the end of the day it all ends in tears.

Unsurprisingly similar issues are also arising in Japan, although please kindly note that they are arguing the exact opposite to Trichet, in the sens that the monetary policy link has been broken since the mid 1990s. Trichet and co at the ECB would do well to examine the Japanese experience more closely:

Most BoJ officials are dismissive of Mr Takenaka’s analysis, arguing that the link between money supply and nominal growth has broken down since the mid-1990s when Japan first slipped into deflation. Flooding the markets with liquidity did nothing to stimulate broader money supply, bank officials argue, so draining it off should have no impact on real economic activity.

The bank, which holds a policy board meeting on Thursday, is highly sensitive to any suggestion that its actions could be damaging the modest but long recovery, now into its fifth year. Shinzo Abe’s government has told the bank, an independent body, to support growth.

Toshihiko Fukui, BoJ governor, has said the bank will keep interest rates low for a long time. However, he has also made clear it will not refrain from acting pre-emptively against inflationary pressures.

Takatoshi Ito, a member of the government’s powerful economic policy council, says the BoJ does not appear to understand that the risks of tipping back into deflation outweigh those of acting too slowly against inflation. He accused the bank of targeting interest rates, rather than inflation, something the BoJ firmly denies.

Monetary Squeeze Hurting Japan

Well I hope young Claus is busy dusting-off his best suit, because someone somewhere should be thinking of giving him a prize, since against all odds he has been consistently in the right on Japan.

Now of course the big guns are starting to wade-in, since reality is impossible to ignore forever, and today it is the turn of Heizo Takenaka, described by the FT as the "architect of the previous administration’s economic policy":

Mr Takenaka, a former financial services minister often credited with laying the foundations for Japan’s current recovery, said the BoJ was rushing to normalise monetary policy.

“It will take two or three years to normalise the situation,” he said. “But the BoJ is too urgent, too rapid.”

Since March, when the BoJ ended its ultra-loose monetary policy, the central bank has been draining liquidity, and in July it raised interest rates to 0.25 per cent, the first increase in six years.

Mr Takenaka said it was premature to squeeze money supply so aggressively when prices, as measured by the gross domestic product deflator, were still dropping 0.8 per cent a year. “Who is responsible for that?” he said. “Is the government responsible for that? Are companies responsible for that? No. The BoJ is responsible for that.”

The outspoken Mr Takenaka, who has returned to academia since leaving the government in September, has been a long-time critic of the central bank. But his latest attack is particularly blistering in linking the current economic slowdown with BoJ policy.

Third-quarter GDP numbers, due out on Tuesday, are expected to show the economy is weak or even contracting. On Friday, data showed machinery orders slipping 7.4 per cent from the previous month, sparking concern that companies might be cutting capital spending. “We cannot ignore the poor BoJ management of monetary policy [in this],” Mr Takenaka said.