Japan - The Fundamentals Linger
Many clouds surround the coming decision by the BOJ to raise rates to 0.75% or whether to stay put. Today's rather dim data on domestic consumption further adds to the issues facing the BOJ at the August meeting. However, there also seems to be mounting evidence that what seemed to represent a sustainable recovery based on domestic demand at the end of 2006 might well end up being a mere blip as the outlook for the remainder of 2007 is becoming clearer. Over at GEM I have a big review and preview note which points forward for the Japanese economy in 2007 as well as the coming BOJ decision. It is well worth a look if anything then for the graphs which I have compiled. Here is my summary ...
The most important immediate point regarding the Japanese economy is whether the BOJ is going to raise to 0.75% come the much expected August meeting. Just a week a ago the implied probability of a hike which could be derived from various market derivatives and indices stood firmly above 70% towards predicting a 0.75% refi rate in Japan by the end of August. However, with the recent disappointing data on wages and consumption expenditures in June out today the overall sentiment towards a hike has cooled significantly in line with expectations as they have been laid out recently on Japan Economy Watch. This does not of course mean that the BOJ could not press on regardless but as I have also argued above the coming August decision will be a test on the acclaimed willingness by the BOJ to raise in the midst of deflation and down trending consumption spending on the back of solidified expectations of future sunshine. I maintain my view that it will be a hold but there is considerable risk attached to this call in the form of how the BOJ could act on future inflation expectations as well as to maintain its image in financial markets of a central bank devoted to the normalization of interest rates.
In a more long term and structural perspective I have also emphasised above how little has changed in the Japanese economy despite many an economic commentator's claim to the contrary. In this way I argue, through my data presentation above, that Japan is not set on the path of a sustainable recovery driven by domestic demand but rather still 'stuck' with the reliance on export and export driven capex to grow. This growth path which in my opinion is a fundamental result of Japan's demographic profile raises important questions and essentially puts Japan in a dilemma which is not, as far as I know, treated in any economic textbook. This dilemma centers around three inter-connected challenges of how to deal with lingering deflation, how to keep the public finances on a sustainable path as well as how to maintain external credibility as regards to monetary governance. In this note this dilemma was conceptualized on the venue of monetary policy where the BOJ needs to factor in much more than external pressure to unwind the carry trade in an orderly fashion. This is not to say that the current global liquidity situation is not creating distortions which might abruptly unwind but it is to say that it is more complex than just laying the blame at Japan's door.