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Tuesday, February 20, 2007

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.


Scott said...

It seems to me that the primary fact that the Bank of Japan should be considering is that it must raise rates at some point. The dilemma lies in determining when the best time to absorb the economic and domestic political pain will be. I agree that raising rates at this point would be a mistake. Here's why:

1. The full weight of economic theory and experience indicates that rates shouldn't be raised when prices are falling, as you state. Going against what one might call "generally accepted economic principles" would come back to bite the BOJ if they don't get the desired result from a rate hike at this time. The second-guessing and loss of credibility would be very damaging.
2. The strengthening in the yen vs other currencies that would occur if rates are raised now would damage Japan's export earnings at a time when exports are essentially the sole source of GDP growth for Japan.
3. There is a finite amount of yen available for use in the carry trade. Unless the BoJ is "printing money", which I think is unlikely, the increase in the size of the carry trade due to market reaction to holding rates steady should be manageable. If one thinks in terms of the discounted cash flow method of valuing economic activity, pain later is better than pain now.
4. I think that current exchange rates provide a sound indicator of how the collective wisdom of the market views the relative strengths of the world's various economies. If EU ministers have a problem with the relative strength of their currency versus the yen, too bad! The Bank of Japan is responsible for the welfare of its constituent citizens and their financial system.

Scott said...

Well, apparently the BoJ doesn't attach too much significance to my opinion:)..it appears that they have gotten something of a good result as the yen has continued to decline in spite of the rate hike. So there won't be a negative effect on exports. I suppose the decline in the yen might be attributed in part to some loss of confidence in the BoJ's decision-making skills as raising in the face of decreasing prices as I discussed in my previous comment goes against the conventional wisdom.