Japan in 2007
I know that we are currently in the midst of the holidays and that you are probably still digesting the Christmas dinner. Yet, I still believe I would try to round up at least one of the major topics here at AS in 2006. Consequently, what is going to happen in Japan as we move forward into 2007?
Predictions of this kind are of course always hazardous to make since economists get them wrong all too often but I am going to stick my neck out anyway. First off, I need some counterbalance though and to that end let us take a look at what the big guns are saying shall we? Firstly, we have the Top 10 of economic predictions for 2007 by Global Insight where the chief economist Nariman Behavesh argues that the BOJ is likely to have raised to 1% by the end of 2007; this would then imply three 0.25% steps from the current level 0.25%. As you will see this is a part of a broad discourse concerning how global interest rates differentials will narrow as the Fed is going to cut while the BOJ and the ECB are going to raise; for the record I do not see this happening at all!
Global Insight expects that the Fed will cut interest rates three times next year, bringing the federal funds rate back
down to 4.5%. The cuts could begin as early as March, but no later than May. At the same time, the European Central
Bank is likely to raise rates at least one more time, probably next March, leaving the overnight rate at 3.75%. Similarly,
we expect that the Bank of Japan will raise rates from 0.25% today to 1.0% by the end of 2007, and that the People’s
Bank of China will hike a couple of times next year.
Global Insight's discourse on Japan is a bit inconsistent though since the consultancy also predicts overall growth in Japan to slow down in 2007 with core inflation also staying at the very low end of the chart.
(...) we expect Japanese growth to down shift from 2.7% this year to 1.8% in 2007. Slower global GDP and import growth will ripple across the rest of the world. (...) Core inflation in the Eurozone should remain below 2%, while core Japanese inflation is still slightly negative (by some measures).
Ermm, not to be scrooge or anything but how do we reconcile an overall slowdown from 2.7% to 1.8% and a very low core inflation rate with a three step central bank rate hike? Clearly, the cause and effect are subtle here since the rate hikes themselves could prompt the effects Global Insight are talking about but methinks that the underlying discourse here is one of a Japan which can actually muster a process of normalization of interest rates.
The second 'big gun' I am featuring here is the Economist Intelligence Unit (EIU) who is also rather bullish on the Japanese economy. I am generally very positive concerning publications and material from The Economist and EIU but on Japan I am outright disappointed, especially the words and expressions annoy me. For example, 'Japan's economic recovery is on track', and '(...) to persuade the bank [BOJ] to reverse its overall tightening course.' What economic recovery? And even stranger, what 'overall' tightening course? To be fair though, let us look at what the EIU actually have to say ...
Indeed, the Economist Intelligence Unit has revised down its forecast for GDP growth in Japan in 2006 and 2007 after a sharp downward revision of third-quarter national accounts figures. Nevertheless, we expect the Bank of Japan to raise interest rates in January, and we maintain our assessment that Japan's economic recovery is on track.
In fact the EIU includes, as well as Global Insight, a lot of the recent rather disappointing data on consumer spending which obviously continues to put the BOJ off its raising track (if they were ever on such a track).
Indeed, the BOJ governor, Toshihiko Fukui, admitted that recent data had been "somewhat weak" and suggested the bank was waiting for further statistics on consumer spending and prices before making a move. Despite this decision, we maintain our forecast that the bank will tighten monetary policy in January.
However, the EIU's take on domestic consumption is what surprises me the most ...
The outlook for Japan's exporters is also broadly favourable. Japanese exporters will continue to benefit from the relative weakness of the yen in the coming months in both nominal and real terms (...).
Yes yes ... this is exactly the point. Growth is export driven here! But then we get this ...
We do not believe, however, that such a slowdown [in exports], if short-lived, would have a significantly negative impact on Japanese domestic demand, which is increasingly looking self-sustaining.
Let us chew on this for a moment ... 'self-sustaining' domestic demand? I am sorry but I just do not see from where such an analysis can come from?
So there you have it ... the Japanese recovery is on track, so much in fact that the BOJ can 'continue' the process of normalizing interest rates. The key components of this discourse is the coming surge in domestic demand as the perky corporate sector sentiment ripples through the economy and a domestic inflation rate which will be pushed up as the labour market tightens (i.e. wage-push inflation).
Allow me to differentiate the analysis just a bit ...
First of all we have the lingering perception that the BOJ is going to raise in 2007. In fact, the idea that the BOJ was going to raise rates in order to scoop up excess liquidity in has been a stubborn part of mainstream analysis ever since the BOJ ended ZIPR (zero-interest-rate-policy) earlier this year. Yet, somehow the party just keeps on being put off.
The yen fell after government reports on inflation and spending suggested the Bank of Japan will keep interest rates on hold at a policy meeting next month.
Japan's currency declined against 16 of the world's most- actively traded currencies in December as interest-rate futures traders trimmed bets for an increase in borrowing costs in January. Central bank Governor Toshihiko Fukui yesterday said consumer prices and consumption are weak.
``The data aren't strong enough to fuel expectations for a January rate hike,'' said Akifumi Uchida, a deputy general manager of the marketing unit at Sumitomo Trust & Banking Co. in Tokyo. ``There's a bias for selling the yen,'' he said.
I know that it might seem futile and pointless to counter the analyses from Global Insight and EIU with a quote from Bloomberg but this is what it is all about. When will we sit down and realize that the fundamentals in Japan merit a different view? Consumer spending is not bouncing back, inflation is staying near deflation territory, and thus the Japanese economy keeps on being driven by exports as a result of the low Yen. I believe there are sound theoretical foundation to argue this trend will continue in Japan and that in fact ZIRP is much closer than a raise. As a result, the idea to apply textbook theory to the Japanese economy is just not working at this point ... how much longer, for example, can one reasonably continue to argue that the tightening labour market will push up inflation? The unemployment rate is down to 4% and still there does not seem to be any feedback mechanism with inflation as indeed the textbooks would predict. Why? Well, I have a whole slew of posts here and also the blog Japan Economy Watch which is an aggregate of me and Edward Hugh's Japan posts is a good place to go. To put it briefly, we believe that the demographics of Japan are given way too little attention and that if we deploy demographics as an analytical anchor we can understand what is going on in Japan.
In terms of my own concrete predictions on Japan I promised to stick my neck out so here goes ...
Growth in Japan
The key point here is that it will remain to be driven by exports and as such the Japanese growth performance will depend on others. China and the US are important here and if China indeed looses momentum and if the US grinds to a hold this will heavily affect Japanese growth rates. The first quarter of 2007 will be important here. In terms of domestic dynamics I believe that consumer spending will continue to drift downwards and that inflation will remain low flirting with deflation. Regarding concrete numbers I am not at all unwilling to accept Global Insight's and the EIU's overall forecast of a downgrade from 2.7% in 2006 to 1.8% in 2007. The big issue here is Japanese trend growth and looking at this cyclically I believe that Japan has been running well above trend in 2006 driven by strong foreign demand. Consequently, if foreign demand for Japanese goods stay strong we can expect Japan to perform very well indeed. This is another indicator of how the inflation dynamics in Japan are not responding to textbook theories because the domestic economy is detached from an indeed very strong and competitive Japanese export sector which continues to spawn significant momentum in Japan. Returning lastly to the concrete forecast the key issue will be the inflation rate and if Japan falls back into domestic deflation growth rates can become severely depressed in 2007.
Inflation and the BOJ
Given my statements above about the continuing downtrend of domestic consumer spending I don't believe that the inflation rate will merit the BOJ to raise. This is of course a question of the chicken and the egg but if indeed the BOJ goes forward with a first quarter raise in 2007 I see a distinct risk of Japan slipping back into deflation. Consequently, I disagree heavily with for example Global Insight's prediction of a 1% interest rate by the end of 2007. In fact, I believe that the return to ZIRP is a more likely outcome in 2007 than a BOJ raise.
The Labour Market
I predict that the labour market will continue to tighten but that this will not have a significant effect on inflation. The key here is that I see the tightening labour market largely as a structural phenomenon due to an ageing population. Clearly, the cyclical component cannot be neglected but the big test case is whether the tightening labour market will push up inflation as seems to be the consensus forecast. Because of the relatively significant structural component of the Japanese labour market dynamics I don't agree with the consensus here. Another big test case is whether the labour market will continue to tighten despite significant lower growth rates in 2007; if it does the evidence of the structural component will be augmented.
There you have it ... my predictions for Japan in 2007. Remember to let me eat my words if I am wrong :). Lastly, you can also see the latest on Japan from Morgan Stanley on Japan where they outline their so-called 'risk scenario' of Japan. At least some of the 'big-guns' are hedging their bets it would seem.