Too Close to Call?

The dust has only just settled since the BOJ chose to hold rates in the end of January contrary to general market expectations. Of course, the debate on carry trade is still wide awake and going strong with my colleague Artim providing the latest contribution over at GEM. I will have more to say later this week. Returning to the forthcoming meeting at the BOJ this week the forecasters are taking due notice at the precarious situation and subsequently terming the situation as 'too close to call.'

(from Bloomberg)

The Bank of Japan's decision on whether to raise interest rates this week is too close to call because policy makers may be more concerned about slowing inflation than accelerating growth, economists said.

Twenty-six of 49 economists predict Bank of Japan Governor Toshihiko Fukui and his colleagues will keep the key overnight lending rate at 0.25 percent at the end of a two-day meeting on Feb. 21, according to a Bloomberg News survey. There is a 61 percent chance of a rate increase, according to calculations made by Credit Suisse Group based on interest-payment trading.

It'll be ``a very close call,'' said Jan Lambregts, head of research at Rabobank International in Hong Kong. ``Having not moved in January, when the market was very much expecting it, they now have to consider whether enough has changed in the meantime to justify a 25 basis-point rate hike in February.''

Of course, the strong 4th quarter figures in Japan are coined as a 'strong tailwind' for a raise but I am not sure I agree with this analysis since the 1st quarter of 2007 has the potential to report a relative q-o-q slowdown coupled with inflation still running very low. A hike here in the middle of the 1st quarter could very well push the economy in the wrong direction because after all, this tailwind might not blow forever. Moreover, the political authorities are also scurrying around in the background urging the BOJ to make the 'right decision' which of course had pretty direct market implications on the Yen today as it fell to a six week low. The underlying is the same as last time where it was widely held that the BOJ submitted to political pressures to keep rates in check. In short, any domestic political comments here are seen as a proxy for the need/demand to keep rates in check. On the other hand of course, we have exactly the carry trade and the perceived need for the BOJ to act on the risk presented by the accumulation of risky positions. In that light, a gradual tightening would make sense and the international institutional pressure on the BOJ to follow such a path is mounting.

Alpha.Sources' Call Then?  

I have to side with the general market sentiment in the sense that this one really is a close call. If pressed, I would argue that the BOJ held rates again this week as a fundamental reflection of inflation still being very low and indeed being pushed down by a dropping headline inflation rate. However, I also think that a scenario is emerging in which the BOJ might actually be forced back into ZIRP. I call this scenario 'one-up-two-down' as it outlines a situation in which the BOJ on the basis of pressures to unwind carry raises to 0.5% but then has to revert back into ZIRP. I have called before that I think ZIRP is a very distinct risk sometime in 2007 and it might very well happen on the back of a premature raise which takes Japan into deflation. The carry trade is a enforcing factor here as a raise would cause the Yen to appreciate rather strongly in the very short term which again would almost surely push Japan into deflation. We need to think of the assymmetric relationship here between the Yen's fluctuations on the back of general market commentaries and the structural difficulty for Japan to actually escape deflation if it it really begins to bite; as such, an appreciating Yen on the back of a hike be it only moderately sustained and perhaps even relatively soft could still very well tip the wagon for Japan I fear. 

Ending finally on this week's decision it is clouded by the BOJ's reliance on the Q4 06 GDP figures. If these figures are used to justify a hike I believe my 'one-up-two-down' scenario to be a distinct possibility going forward.

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