Japan's revenge

Over at Project Syndicate, Thomas Palley outlines the argument about how the yen carry trade is fuelling global asset bubbles — although Finance Minister Omi denies that Japan's low interest rates are the cause of the carry trade.

Aside from rehearsing the standard arguments about how Japan's barely-over-zero interest rates contributes to global instability and the appreciation of the dollar, Palley also suggests that Japan's lagging growth in consumption could be corrected with an interest rate hike because a hike could signal to Japan's elderly that their income is safe over the long term: "Current ultra-low interest rates may be scaring people about the adequacy of future income. Raising rates could alleviate those fears, increasing consumer confidence and spending."

In Chicago on business this week, I had a conversation with my father — whom I should probably have write here from time to time — about the global risk environment, and he noted wryly that the carry trade is Japan's revenge for the 1987 Louvre Accord, which mandated that Japan permit the yen to rise as the dollar fell, correcting for the overshooting of the 1985 Plaza Accord. The outcome of the Louvre Accord was Japan's asset bubble, bringing us — after the interlude of a "lost decade" — to where we are today, with Japan in no hurry to be the first to alter its monetary policy to correct global imbalances.

Will the Bank of Japan raise interest rates again? Knowing Fukui's eagerness to "normalize" Japanese monetary policy, it seems like a matter of time — although probably not until after July's Upper House elections.

The one certainty though is that it will be at a time of Japan's choosing, not the product of pressure (in the G7 for example) to alter its policies to carry a greater share of the burden of global readjustment.

And all that is a long way of saying that I'm back in Japan, after an unplanned overnight stay in San Francisco, so my posting will be back to normal

Quantative easing continues

So the BOJ opted to raise interest rates by .25%. Ken Worsley has the wrap-up here.

It seems that the effect on the carry trade will be negligible; the EU will no doubt still complain about the weak yen; and the BOJ's independence is still in doubt.

Interest rates, again

The Bank of Japan is due to consider once more tomorrow whether it is the right time to raise Japan's interest rates again.

The last time, you may recall, the Bank's policy meeting was surrounded by a storm of debate surrounding comments by senior LDP and government officials questioning the wisdom of raising rates again (discussed in this post).

This time, however, a mere month later, following the Yanagisawa storm and the threat of G7 action on the weak yen at its meetings in Germany earlier this month, there's nary a peep out of the government or the LDP, unusual for the Abe Cabinet, which has been described as having "foot-in-the mouth disease."

Ken Worsley, of Trans-Pacific Radio and now the Japan Economy News & Blog, summarizes the relative lack of silence on tomorrow's meeting in this excellent post.

His conclusion: "...I don’t think the fundamentals are actually there for a rate hike, unless one prefers to go by some funny numbers."

I'm inclined to agree, but, then again, I've previously described BOJ President Fukui as having an "itchy trigger finger" as far as interest rates are concerned, and this might be a rate hike the Abe Cabinet can get behind: a rate hike could be used by the GOJ to point out to concerned Europeans that the government isn't tampering with the yen, with the recent GDP number -- however ambiguous -- providing cover for the move. Without the public fuss, a rate hike could allow the BOJ to reassert some semblance of independence -- however the reality plays out in invariably smoke-filled rooms in posh drinking establishments.

So the question of how big the rate hike will be depends on one's view of how Japanese monetary policy is made. If the BOJ is truly independent, look for something bigger, perhaps even on the order of fifty basis points; if it's not, look for something smaller, that serves both the government's and the bank's political needs.

Much ado about nothing in Essen

So the meeting of G7 finance minister and central bank presidents has concluded, and, despite grumbles from the Democratic US Congress and the EU's ECOFIN about the weakness of the Japanese yen, the final statement in Essen included nothing that directly referred to Japanese monetary policy.

Instead, the only country named directly in the paragraph on exchange rate policy is China, together with other developing countries:

We reaffirm that exchange rates should reflect economic fundamentals. Excess volatility and disorderly movements in exchange rates are undesirable for economic growth. We continue to monitor exchange markets closely, and cooperate as appropriate. In emerging economies with large and growing current account surpluses, especially China, it is desirable that their effective exchange rates move so that necessary adjustments will occur. (Statement available for download here)

So Japan has once again been granted a reprieve, with China remaining the favored scapegoat of developed countries feeling the crush of competition from the BRICs and the rest of the developing world. Perhaps the G7 balked at the potential consequences of a statement that might spark the rapid "unwinding" of the yen carry trade.

In any case, the yen remains weak, Japanese interest rates remain extremely low, and the G7 remains a body with questionable relevance in the rapidly changing international system.

Second time farce...

An embattled George Bush in the White House, a Democratic Congress riled up about Japanese practices to give itself an unfair advantage in international economic competition...is it 2007 or 1992?

But seriously, as this FT article reports, Congress is pushing hard for Secretary Paulson to join with European governments to pressure Japan to raise interest rates and push up the yen.

What exactly do these esteemed members of Congress hope to achieve? Do they expect that if Japan changes its supposedly errant ways that America's economic concerns will vanish and its economy will continue to lead the world? (I say supposed because it's not exactly clear how Japan is manipulating its exchange rate, aside from having extremely low interest rates.)

As I've posited here before, America's problems are rooted in the long-term challenges associated with the move to a post-industrial economy, and no amount of badgering of foreign governments will solve the long-term question of how to re-envision American institutions for the new era. Not surprisingly, John Dingell (D-MI), is leading the charge on this issue; it seems that Dingell, whose district includes the suburbs of automobile industry-dependent Detroit. It seems Dingell would rather freeze American industry than advance measures that will strengthen American dynamism and ensure that the engines of growth continue to purr -- including Detroit. There's no going back to 1950. And frankly, since a world with many major liberal economies means that millions, if not billions, of people are being lifted out of poverty, we shouldn't want to go back to 1950 even if we could.

Dingell and his fellow Democrats should be using their majority to ask how to provide some degree of assistance in the short term to those affected by the post-industrial transition, and to consider long-term solutions to ensure that rising generations have the skills to compete in new global economy that has many major nodes, with which competing fiercely for an edge on the rest. Undermining the global economy by hectoring foreign governments is a solution to neither the short-term nor the long-term problem.

So to re-enact the early 1990s efforts to pressure Japan to do America's bidding economically, given what we know now about how the global economy is changing, is indeed a laughable farce.

Japan walking into a trap at Essen?

The G7 is due to meet in Essen, Germany this weekend, and there are dark rumblings that Japan may be called to account for failing to allow its currency to rise as the dollar falls, which has forced the euro to appreciate to a greater extent than the yen, which has remained the weakest of the major currencies.

At a recent ECOFIN (that's the Economic and Financial Council of the Council of the European Union -- the finance ministers' group in the European presidency) meeting, German Finance Minister Peer Steinbrück and French Minister of Economy, Finance and Industry Thierry Breton suggested that the weakness of the yen would be on the table at Essen. In Breton's words, "We agreed that the yen ought to reflect the reality of the Japanese economy" (From Jiji, in Japanese).

That was from 31 January.

Just before that, however, US Undersecretary of the Treasury for International Affairs Tim Adams said at Davos that the US viewed Japan's economic policy as "appropriate," suggesting that any attempt by the European members of the G7 to cajole Japan into allowing the yen to bear more of the burden of the dollar's fall would be nixed by the US.

Recent changes in the US, however, suggest that Japan may in fact be confronted in Germany.

First, Adams tendered his resignation on Friday. His letter gives the usual "more time with my family" excuse, but I can't help but wonder if there isn't a dispute going on in the upper reaches of the Treasury Department over how the US should deal with currency manipulation. As Ken Worsley notes in this post at his Japan Economy News blog, Congressman John Dingell (D-MI), chairman of the House Energy and Commerce Committee, apparently wrote a letter to Bush calling for the administration to press Japan on the currency issue. (Apparently if China won't budge, Congress can always turn to Japan as a scapegoat.) Maybe Secretary Paulson is caving on this front.

Second, I wonder how the Kyuma dispute plays into all this. The Bush administration, after all, isn't known for being especially charitable to critics, and Kyuma trod upon the administration's toes -- well, toe, probably the pinky toe -- just as it struggled to sell the new course in Iraq to the American public. While alliance managers have traditionally tried and mostly succeeded at keeping the economic and security realms separate, I can't help but wonder if the Bush administration, embattled at home and abroad and short on prominent Japan hands, isn't particularly concerned about breaking with tradition in the US-Japan relationship.

As such, should Japan face a united front of criticism from the rest of the G7 in Essen, it could be a crippling blow for the already tottering Abe Cabinet. Combined with the boycott of budget hearings by the opposition as a result of l'affaire Yanigasawa, pressure from the G7 to change course at home could further paint Abe into a corner.

Is it too early to start placing bets on how many more months (weeks?) Abe has before being ousted?

Will they or won't they?

The "they" in the title of this post are, of course, the members of the Bank of Japan's Policy Board, and the 120.54 million yen question is whether its members will vote to raise interest rates on Thursday.

Call me naive, but I'm used to the Fed's way of doing business, namely advertising the direction of its next move long in advance so various actors in the economy (domestic and global) have plenty of time to factor the central bank's anticipated policy direction into their decision making.

Japan, meanwhile, seems to have concluded that predictability is overrated. First, senior members of the LDP openly questioned the wisdom of a rate hike last weekend, as I discussed in this post, raising questions about even the circumscribed independence of Japan's monetary authorities. Then, as if to throw the markets a curve, Omi Koji, Japan's finance minister, stated matter-of-factly yesterday that he sees no problem with the BOJ raising interest rates, and, to muddy the waters even further, Chief Cabinet Secretary Shiozaki declined to comment on the prospect of a rate hike. (See this article in the Yomiuri Shimbun).

And then, to throw tomorrow's outcome completely into question, Reuters is now reporting that the BOJ is "unlike to raise rates."

In the midst of the speculation regarding the short-term direction of Japan's monetary policy and with it Japan's economic recovery, it's worthwhile to check out this interview in the English edition of the Asahi Shimbun with Koizumi economy czar and current Keio University professor Takenaka Heizo, in which Takenaka calls for, among other things, inflation targeting by the BOJ. But he also once again implicitly criticizes the Abe Cabinet for its reluctance thus far to push forward with what he calls "proactive reform."

This is indeed curious. Economic reform was pretty much the raison d'etre of the Koizumi Cabinet, but it seems that reforming the Japanese economy so that it remains dynamic and prosperous is too pedestrian for Prime Minister Abe -- he apparently likes a challenge, like completely remaking Japan's institutions as they have existed since the end of World War II.

Open Stackelberg Warfare in Japan

I have previously noted tension between the Bank of Japan and Abe Shinzo's governing coalition regarding the timing of the next round of interest rate hikes. It seems that that tension has become open warfare between monetary authorities and LDP and government officials in advance of this week's meeting of the BOJ's Policy Board.

As this article in the English language edition of the Asahi Shimbun reports, BOJ officials have been encouraged by recent positive signs in the economy and are likely to opt for a hike this week, notwithstanding a muted warning from the prime minister and more open criticism from LDP Secretary-General Nakagawa Hidenao.

I have a hard time imagining what the government stands to gain from an open campaign against a rate hike. Protecting itself from potential negative consequences of a rate hike (i.e., having "we told you so" soundbites ready in advance)?

I still think that BOJ President Fukui has an itchy trigger finger as far as interest rates are concerned, because Japan's economic recovery has yet to spread from industries to households (indeed, a major concern now, as David Pilling wrote here in the FT, is that income inequality has grown substantially even as the economy has supposedly emerged from the doldrums). So the government and the LDP may be right that a rate hike is probably premature, but too much public criticism of the BOJ's handling of monetary policy risks undermining market confidence in Japan's economic authorities and highlighting the vacuum in economic policymaking under the Abe Cabinet.

Nikkei sends a warning shot across the bow

Nikkei's lead editorial today discusses a meeting this week between Prime Minister Abe and BOJ President Fukui.

The meeting itself was uneventful, but Nikkei uses the occasion to warn of undue political pressure by the government on the BOJ in advance of the 2007 elections. It concludes with a call for the government to respect the Bank, saying, "The ideal is that the government respects the central bank's independence and discretion, and the central bank provides reliable medium-term monetary policy management to the nation and the market. In order to move slightly closer to this ideal, the Bank of Japan and the government must both exert considerable effort."

Nikkei's warning may be anticipatory, rather than based on any specific government policy (as I discussed here, Finance Minister Omi Koji has made supportive statements regarding the BOJ's intentions to raise interest rates before year's end). But as the elections get closer, and if Abe's popularity numbers continue to fall, the temptation to tamper with economic management for short-term political gain could prove irresistible.

The editorial further warns the BOJ to assess economic conditions carefully before raising Japan's interest rates, noting that current international and domestic economic signals are mixed -- and the biggest question, that of whether the US economy will have a "soft landing" remains unanswered. So while Nikkei doesn't come right out and say that the BOJ shouldn't raise interest rates, there is a very strong undertone throughout this editorial that suggests that all parties involved in the management of Japan's economy need to think very carefully before acting and not act rashly, lest the authorities scupper the longest boom in Japanese history.

Takenaka criticizes Fukui (and the Abe cabinet?)

With the Bank of Japan sending signals that it will raise Japan's interest rates soon, Takenaka Heizo, former Prime Minister Koizumi's point man on the economy and structural reform, has criticized the BoJ (and implicitly its president) for prematurely tightening monetary policy, reports the FT.

For a high-ranking "Koizumian" to criticize Japan's monetary policy -- which was defended in the FT by current Finance Minister Omi, as I discussed here -- suggests that the LDP might be fractured on more than the nuclear weapons question.

Are we looking at the beginning of an LDP crackup leading up to the Upper House elections?

It is too early to say, but the DPJ has been aggressive recently, pushing back on all fronts in the special Diet session. It has sought to delay the passage of the bill upgrading the Japan Defense Agency to a full ministry, demanding answers to questions regarding a bid-rigging scandal in the JDA's Defense Facilities Administration Agency that rocked the JDA earlier this year. It has hammered, albeit with uncertain success, the Abe Cabinet on nuclear weapons. And now it is looking to prevent the revisions of the education law from coming to a vote.

Should economic growth soften, as observers fear, and the BoJ raise interest rates regardless, economic management could become another contested front, particularly if others join Takenaka in criticizing Japan's monetary policy (and the cabinet, implicitly, for not questioning the BoJ's wisdom publicly). Japan's Democratic party could then borrow from its American counterpart's playbook and run on a campaign criticizing the Abe cabinet's lack of competence.

Unfortunately, this chain of events would mean borrowing from Lenin -- the worse things get, the better for the DPJ -- but it might be the only way for the DPJ to win a major victory next summer. The policy differences between the LDP and the DPJ are too slight for the DPJ to build a campaign on anything other than personality and competence at governing.

Fukui's itchy trigger finger

It seems that while Prime Minister Abe is busy fending off opposition attacks in the Diet on nuclear weapons, Fukui Toshihiko, the president of the Bank of Japan, has been signaling that the BoJ will be raising interest rates again soon, this despite ambiguous signs about the strength of Japan's recovery.

There are serious questions whether the time is right for Japan to rise its interest rates again, as this interview in the FT with Finance Minister Omi Koji by David Pilling and Martin Wolf indicates. This bit is of particular interest:

Paul Sheard, global chief economist at Lehman Brothers, said he was concerned that Japan's economic authorities were applying the brakes at the wrong time. "The big picture in Japan is that deflation continues and monetary and fiscal policy are both being tightened," he said. "I challenge you to find any textbook where that is described as an optimal policy mix."

Of course, economics textbooks are far from infallible. Nevertheless, the point is a good one.

This remark is interesting in light of the Abe Cabinet's latest push to trim the budget. Reducing Japan's colossal deficit -- in part the product of pump priming in the depths of Japan's "lost decade" -- is a necessary and long-term task for Japan's government (previously discussed here). Because the government is committed to contractionary fiscal policy for the indefinite future, however, the BoJ must exercise extreme caution in its monetary policy decisions in the coming year. Anything more than a light tap on the brakes could bring the Japanese recovery to a screeching halt.

One impact of an interest-rate hike that overshoots the mark could be an unwinding of the carry trade -- moves by global investors to take advantage of Japan's low interest rates to buy cheap yen and then turn around and sell it for currencies with better returns (i.e., higher interest rates). As this article in the FT suggests, interest rate hikes designed to preempt inflation could have the perverse consequence of leading yen to flow back into Japan, raising the exchange rate, which would likely have severe consequences for Japan's economic recovery. But then, I am probably the wrong member of my family to ask about the carry trade.

The data on the course of Japan's recovery is probably too mixed at the moment to make a firm judgment as to its sustainability, and the BoJ may be acting a bit too hasty to be assuming that the next two years will see growth continue unhindered.

Politically speaking, I wonder whether Japan's new air of confidence could survive a serious economic downturn. At the same time, though, a downturn could obviate the need to consider a consumption tax hike, about which Mr. Abe has determined no decision will be made until autumn 2007, after the Upper House elections.