Wednesday, February 21, 2007

The BOJ Hikes Again

The Bank of Japan raised its benchmark interest rate by 0.25% to 0.50% in an 8-1 vote. I found it particularly interesting that Governor Toshihiko Fukui actually mentioned the carry trade in discussing the move: "We're aware that extremely distorted movements in the financial markets, including the yen carry trade, could eventually have a negative impact on the economy."

I've been pondering the Japanese situation, and something has been nagging me for a while. First I note that Japanese CPI is still a mere 0.3%, and real GDP is a modest 2.1%. Normally that's the sort of figures that would call for easing money policy, not the other way around. But Japan has been doing that for a loooooooooong time now to no avail.

Let's take it as a given that the relationship between the effective money supply and consumer prices is absolute. We must then assume that the effective money supply is barely growing in Japan. This despite the BoJ literally giving money away through zero interest rates for most of the last 7 years.

If money is being created but goods prices aren't rising, then the money created isn't being spent on goods. But Milton Friedman hasn't been revoked. If there is more money in the system, then something has to be rising. Unfortunately for the Bank of Japan, global financial integration is allowing the money the BoJ is creating to flow overseas. Perhaps Japanese investors see better opportunities abroad. Perhaps consumers in that nation are fearful about their own future and are more inclined to save. Whatever the reason, the money is obviously not flowing into the goods market. Instead, its flowing to non-Japanese investments, causing various investments world-wide to be trading at historically high levels.

So far, I'm saying nothing unique. But consider the consequence for central bankers of this episode. Bouts of deflation may become extremely difficult to combat anywhere in the world if the result of low interest rates is simply a flow of investment capital out of a country with no appreciable impact on consumer prices. Perhaps the U.S. is in a favorable position in regards to this issue, because our population has a high marginal propensity to consume. But this is all making it tough for me to read what the impact of rising Japanese rates will be. Maybe the BoJ starts hiking, and deflation appears a new. Then we're back to the ZIRP, and the asset bubbles continue to boil. Maybe the BoJ hikes rates and the yen carry trade whithers, but at the same time the yen strengthens and the export economy stagnates. Maybe a financial accident (perhaps even caused by removal of the carry trade) causes other central banks to cut rates as well, supporting the yen and allowing everything to turn out rosy, at least for the Japanese.

We'll see how it plays out. It sounds like the BoJ wants to take a page out of the Greenspan/Bernanke playbook and hike rates slowly, telegraphing their moves. Whether they are successful in normalizing rates will play a major role in investment returns over the next 2-3 years.


Leonardo said...

There are a coule of points that I can't get my head around and was wandering if you could share your thoughts.

1) A topic seldomly discussed in my view is that of demographics. Not so much vis-a-vis the retiring baby boomers but rather on the ageing of a country's population as whole. Here, Japan is way older than Europe who is older than the US. What this implies to me is that consumption pattern change dramatically (not necessarily diminish) and Japan is an indication of what will happen in Europe (already evident?) and subsequently US

2) The yen story. Ah the yen... You rightly point out that a Yen appreciation would hurt the exporters. However, considering that the ZIRP policy was in part implemented to maintain their competitiveness, the 'benefits' were not reinvested within the economy (capital spending and wage increases) why should these exporters still be protected then? The main reason most people fail to understand is cultural differences. And one thing is for sure is that the Japanese would rather go broke than see the likes of Toyota loosing their status as number one car manufacturer. There is nothing worst to a Japanese than to loose face.

3) If something doesn't work, why not try the opposite? It is evident by now that a weak Yen is not doing the country any good. These guys were so burned from the implosion of the asset (debt?) bubble of the 80s and early 90s that a Japanese household will no longer borrow even if the banks paid them to do so! Wouldn't an appreciation of the yen cause imports to become 'relatively' cheaper and possibly to a better job at stimulating consumption as opposed to dangling the 'carrot of easy borrowing' ? As the saying goes, been there done that, no?

Tom G. said...

There's a lot to respond to here.

I'm sure there are a variety of reasons why spending patterns are what they are in Japan. And demographics will undoubtedly play a huge role in financial markets for the next 20 years.

I also hear what you're saying about cultural differences. I've never been to Japan and what I know of their culture is all about what I've read. I think the culture issue and the demographic issue are playing a complementary role here. Maybe the average U.S. retiree continues to spend at a higher level than the average Japanese retiree.

Would a stronger yen cause more domestic spending and thereby actually increase domestic prices? Interesting question. My gut tells me that Japan would be better off today if they had not depressed the yen so consistently over the years. But I think a strong yen policy would cause a lot of short-term pain, which the populace may not be willing to tolerate.

RW said...

I've been trying to get my hand around this one too and keep recalling that another issue, possibly cultural also, dogging Japan's economy was the incredible level of "non-performing" (actually dead) loans remaining on the books of Japanese banks; they just weren't writing them off.

So the thing that nags it me is a suspicion that, somehow, the mechanics of the BOJ creating money is allowing Japanese banks to reinvigorate their moribund lending portfolios and, hence, improve money velocity in Japan and never mind that the money will likely be exported.

What's in my head is something like a very large scale money laundering scheme with Japan providing funds, countries like China building products, and the U.S. serving as a 'fence' (or consumption sink) converting it all into $USD.

Assuming any of that is accurate I'd say it was a 'virtuous circle' except there's the problem of all that $USD being created; can't keep it all in reserves, gotta buy something with it eventually but not too much because you'll inflate the price of what you're buying (including other currencies).

What if it's less a matter of the $USD falling than everything else inflating (including bond prices)?

Oh geeze, my head hurts.

Vivek said...

If I borrow money in Japan and invest abroad, does that subtract from Japan's financial account? If so, should that not increase their current account and thus act as an economic stimulus?

Furthermore, a weak yen should feed into inflation to the extent to which goods being imported will be more expensive.

If so, it makes it even more bizarre that inflation is not higher in Japan.

Tom G. said...

RW and Vivek are both right. All this money they are creating is going SOMEPLACE. It SHOULD be a short-term stimulus, but it isn't working that way.

That's the conundrum.

RW's money laundering theory is interesting. I personally do not know how the "bad loan" situation sits today. That was a big story years ago, but you don't hear as much about it now. I don't know if its just faded from the headlines or if its been largely resolved. Perhaps the easy money was a way to help solve the bad loan problem but now they are having trouble reversing their policy stance.

Apolitical said...

The bad loan problem is one that has in large part been resolved under the reign of Prime Minister Koizumi.

One of his big reform agendas was cutitng bad loans on bank's books, and he's done that so that they currently stand at half their 2001 levels.