The Meaning of Money
November 14, 2006
By Elga Bartsch | London
Debating the meaning of money Last week, pre-eminent monetary economists and leading central bankers from all over the world headed to Frankfurt to attend the 4th ECB Central Banking Conference on The Role of Money: Money and Monetary Policy in the Twenty-first Century. The ECB’s Executive Board Members were out in full force, supporting the prominent role of money in the ECB’s monetary policy strategy and answering the criticism from prominent monetary economists such as Columbia’s Michael Woodford.
New insights into the role of money
Much of the content of the conference was academic — leading monetary economists presented very interesting new theoretical and empirical research on the role of money in monetary policy. While the different viewpoints, especially the divergence between the European and US view on the relevance of money, would make an interesting subject of study, in this note we concentrate on what we have learned from the papers presented at the conference about the relevance of monetary developments in the ECB’s conduct of monetary policy. A joint paper by several senior ECB economists presented at the conference sheds new light at how the ECB assesses the risks to price stability stemming from monetary developments and how the perception of these risks has affected the ECB’s interest rate decisions in the past (see B. Fischer, M. Lenza, H. Pill and L. Reichlin, Money and Monetary Policy: The ECB Experience 1999-2006). A prominent role of money …
It became clear from the ECB conference that assigning a prominent role to money is supported strongly by the ECB Executive Board. Earlier suggestions that the role of monetary analysis might become less prominent following the departure of the ECB’s former Chief Economist, Otmar Issing, therefore seem increasingly inappropriate. It was, in fact, ECB Vice-President, Lucas Papademos, who opened his dinner speech by stating that the "suggestion that monetary policy can be conducted without assigning a prominent role to money seems like an oxymoron … is pointedly foolish". He then went on to criticise the neo-Keynesian macro models, the workhorse model for many central banks these days, for the unrealistic assumptions they make regarding (1) the irrelevance of real money balances in determining aggregate demand dynamics and (2) the absence of liquidity and credit constraints in the process of financial intermediation. Once these flaws are rectified, Vice-President Papademos believes, the relevance of money will be "revealed and restored". … within the two-pillar framework
Earlier in the day, the new ECB Chief Economist, Juergen Stark, had already outlined the main issues regarding the role of money in monetary policy making in his introductory remarks by saying that the ECB’s "analysis of risks to price stability is based on two complementary perspectives … The first perspective … embodies a thorough assessment of the cyclical dynamics of inflation. The second … analyses monetary trends associated with price developments over the medium-to-longer term". In bringing the two perspectives together in the so-called cross-checking, "the role played by money in interest rate decisions varied over time, as the clarity and reliability of the policy-relevant signal coming from monetary developments has fluctuated". The paper by Fischer et al. suggests that, over time, monetary developments have gained more prominence in the ECB’s assessment of risks to price stability and its interest rate decision. The role of money in ECB interest rate decisions varies
The assessment of the varying role of the monetary analysis is backed by a detailed account of how monetary analysis has affected the ECB’s interest rate decisions in the course of the last seven years given in the paper by Fischer et al. The ECB researchers distinguish four different phases of how monetary analysis has affected ECB interest rate decisions: · Between early 1999 and mid-2000, monetary developments were signalling some upside risks to price stability, but compared with today had only "rather modest" relevance for policy decisions. In this period, the ECB initially lowered interest rates by 50bp in April 1999. It reversed its decision in November 1999 and hiked interest rates to 4.75% by summer 2000. This limited relevance of monetary developments likely reflects the uncertainties created by the start of EMU. · Between mid-2000 and-mid 2001, monetary analysis pointed to intensifying upward pressure on consumer prices while economic analysis suggested the opposite. During most of this period, the ECB left interest rates unchanged at 4.75%, probably partly reflecting the diverging signals from the two pillars. In May 2001, however, the ECB surprised markets by cutting interest rates and pulling out a new definition of M3, which corrected for the non-resident holdings of marketable instruments issued by euro-area monetary financial institutions (MFIs). · In the subsequent phase, between mid-2001 and mid-2004, the ECB was mostly in an easing mode, cutting the refi rate to 2% eventually, notwithstanding strong headline M3 growth. During this period, headline M3 growth was bloated by portfolio shifts and another adjustment in the official statistics became necessary. Hence, "monetary analysis appears to have played a more subdued role in guiding … short-term interest rate decisions". But it "may have acted as a break on more aggressive interest rate cuts in 2002-03", according to the ECB economists. · Since mid-2004, strong monetary dynamics, which, in contrast to the 2001-2003 period, were characterised by strong credit expansion and surging liquid components of M3, were signalling intensifying upside risks to price stability. As the evidence accumulated and the economy started to recover, monetary analysis played a key role in the ECB’s decision to raise interest rates in December 2005, according to ECB President Trichet. Second pillar is less transparent than the first
Compared with the first pillar of the ECB’s monetary policy strategy — the broad-based inflation outlook — the second pillar still seems to be less transparent. While the macroeconomic projections of the ECB staff, which are a key input into the Council’s assessment of the traditional inflation outlook, are published regularly, the staff’s quarterly monetary assessment is not. So far, the inflation projections based on monetary aggregates have only been published twice in the Monthly Bulletin (see ECB Monthly Bulletin, May 2006, for the latest update). A more regular publication of these estimates would help to improve the markets’ understanding of the monetary analysis and its role in the ECB’s interest rate decisions, in our view. Another difficulty for market practitioners is that official M3 data can be distorted, at times, because of financial innovations and structural shifts in financial markets. While the ECB’s desire is to make the corrected data as robust as possible before publishing it, it is sometimes difficult for financial markets to follow its analysis on a real-time basis if the official data are heavily distorted; therefore, they are largely disregarded by the Council and/or adjusted only for internal purposes. While the staff’s assessment of monetary developments is usually echoed by the ECB Council’s assessment as transmitted in the introductory statement to the monthly press briefings, there have been phases in which the two have deviated, notably between late 2002 and mid-2004, when the Council was less concerned than the staff about risks emanating from the monetary pillar. In fact, based on concerns stemming from the traditional economic analysis of the inflation risks, the Council lowered interest rates three times during that period. Implications for ECB decisions at the current juncture
While the paper shies away from commenting on current ECB monetary policy discussions, it is clear from the November press conference that the Council is becoming worried about the renewed rise in money and credit growth (see ECB Watch: Good to Go Again, November 2, 2006). If strong monetary dynamics persist into next year, it would become more and more likely that monetary analysis — having already caused the tightening campaign to start early — could cause it to last longer than the inflation outlook would suggest. Hence, even if the December staff projections were showing relatively benign inflation forecasts, the ECB Council might still be concerned enough about risks to price stability to raise interest rates further, we think.
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When Slow Is Good
November 14, 2006
By Gray Newman | New York
After four years of real GDP growth at nearly 9% per annum, Argentina’s economy is showing no sign of slowing as it enters year number five of robust growth. At first, it was easy to dismiss the strong recovery in 2003 or 2004 as little more than a rebound after the severe downfall which accompanied Argentina’s break from the convertibility regime. But now that Argentina seems poised to enter its fifth year of some of the strongest growth seen around the globe, it is time to revisit the policy mix which has helped to produce its impressive growth record. As much as strong growth is desirable, I suspect that it is time to ask whether Argentina’s recent pace of economic activity is healthy. At first glance, Argentina appears to be running an export-based model. After all, the authorities have clearly aimed at keeping the currency weak in both nominal and real terms. Faced with strong dollar inflows, the central bank has aggressively begun to rebuild reserves — tripling reserves in the past four years — to help limit pressure on the Argentine peso to appreciate. After the abrupt devaluation following the end of convertibility, we estimate that the Argentine peso fell by nearly two-thirds in real terms and has recovered only modestly from the initial fall. But the Argentine model is hardly centered on exports. While export taxes, along with a financial transaction tax, have contributed to Argentina’s improved fiscal performance, exporters have often found that the authorities appear to be first and foremost interested in maintaining ample supply to meet domestic demand. Indeed, exports appear to be a residual: to the extent that domestic demand is met, any excess production can be exported. For businesses fortunate enough to produce goods that are not frequently used domestically, export taxes have remained low. In contrast, businesses in the meat, dairy and hydrocarbon industries have learned that attempts to favor export markets at the expense of domestic demand have been met with resistance from the authorities. Far from an export model, Argentina has essentially put in place an import substitution model. Maintaining the peso weakness seems largely designed to limit competition from imports and hence boost the profitability of domestic production. While there is a long list of criticisms of traditional import substitution models — consumers suffer as domestic producers are sheltered from competition from abroad — it is worth looking at what Argentina’s model has produced so far. Critics of the Argentine model usually start with the growing reliance on price controls. Indeed, we have been critical of their use as well (see "Argentina: Repressed Inflation" in This Week in Latin America, September 25, 2006). But in defense of the Argentine experience, the controls appear to have created limited distortions outside of the energy sector: we have heard of few cases of shortages; for most producers, prices remain free on all but a very limited number of products; and furthermore, our work suggests that repressed inflation is still fairly limited. In contrast, price agreements appear to have strengthened the authorities’ hand in negotiating wage caps. By producing a basic basket of consumer goods for the working class with limited price movements, the authorities have been able to bring Argentina back from a wage spiral, keeping wage hikes to 19% in 2006 and aiming for 13-14% in 2007. The Argentine policy mix of keeping the peso weak, taxing exporters to ensure ample supply for domestic demand and the use of price and wage agreements has produced a dramatic rebound in activity, now well in excess of what was seen prior to the beginning of the downturn in late 1998. The policy mix has helped halve the unemployment rate as well as the percentage of households living in poverty. It is easy to criticize the Argentina model as being a collection of heterodox policies. Indeed I have done so in the past. But given the fragility of the Argentine social net in 2002 and the near-collapse of any institutional framework — recall that Argentina had five presidents in a matter of weeks at the end of 2001 — a program designed to provide a dramatic boost to consumption and incomes was probably in order. At the time, I argued that Argentina’s mix was not sustainable over the long term. While I believe that to be true, it may well be irrelevant. Argentine policymakers were faced with a dramatic challenge in 2002 and needed to take dramatic steps which would produce a rapid turnaround. A litmus test of long-term sustainability may simply have been irrelevant at the time. Dire circumstances, they could argue, demanded a dramatic policy response. That Was Then, This Is Now But that was then and now I would argue that times have changed. Judging a policy solely on the basis of its long-term sustainability might have been a luxury that few policymakers could have afforded in 2002 or 2003. But after four years of dramatic growth, I would argue that super-charged growth is hazardous to Argentina’s health. Perhaps nowhere are the shortcomings of the current policy mix clearer than in the energy sector. By keeping prices from clearing, the authorities have risked shortages and underinvestment as demand has easily outstripped supply. Today it appears that the very policy mix which made so much sense initially is now jeopardizing growth. While it is hard to know just how close Argentina is to more serious electricity blackouts, the risk is greater today with 9% growth than if the economy had been growing in the order of 6% or 7% during 2006 (see "Argentina: Breaking the Boom and Bust Cycle?" Global Economic Forum, October 31, 2006). The central bank can rightly argue that there are limits to what monetary policy can achieve when the credit channel is as weak as it is and when the banking system still has mismatches that can be exacerbated with high real interest rates. But it is difficult to claim that the monetary authorities have done all they could to temper aggregate demand with real interest rates still in negative territory. Monetary tightening after all can help slow demand — increasing the opportunity cost of consuming by making savings more attractive. The greatest quandary today, however, lies with Argentina’s fiscal policy. Fiscal resolve has become the anchor of the current policy mix that distinguishes it from the country’s long history of living beyond its means. Indeed, in recent weeks there has been renewed talk about safeguarding the financial transaction tax from provincial attempts at increasing their share of revenues and even expanding the reach of the tax by requiring all real estate purchases be made via the banking system. But despite those signals and despite the sizeable budget and primary surpluses, Argentina’s fiscal impulse has been stimulative in recent years as the primary surplus has fallen from 5.3% of GDP in 2004 to 4.4% in 2005 to near 3.6% in 2006. I am not arguing that Argentina needs a primary surplus of 5% of GDP or even 4% of GDP; but only note that it seems odd to see fiscal policy on the margin being relaxed even as the economy continues to grow well above its potential growth rate. The precise link between fiscal policy and growth is not clear, but when in doubt and, given the growing signs of potential shortfalls on the energy front, the decision not to try and "lean against the wind" a bit more on the fiscal front in 2006 is puzzling, in my view. Bottom line Argentina’s current policy mix is unlikely to be able to continue indefinitely. However, that in itself is a poor measure of whether the policy mix was appropriate when first introduced. Despite all of the criticisms of the current policy in place in Argentina, the country hardly seems to be at a point of no return. I remember in 1993 hearing Rudi Dornbusch give a speech in Mexico City in which he described the Mexican model of relying on an increasingly appreciated exchange rate as being akin to being in a car heading for a brick wall. There was still time, he argued, for Mexican policymakers to turn the steering wheel. I believe that Argentina still has time. I doubt that Argentina is face-to-face with a crisis today. The key for me is to see if the authorities will engineer a soft landing and give themselves the time needed to adjust prices and incentives in the energy sector and prove the naysayers wrong. Argentina may yet give heterodoxy a good name. The first step should be to help slow the pace of growth as a prelude to resolving some of the emerging distortions seen in the economy today.
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Japan at Lyford Cay -- The Exit from "Clunkritude"
November 14, 2006
By Robert Alan Feldman | Tokyo
What’s new Morgan Stanley’s annual conference at Lyford Cay saw continued strong interest in Japan, despite the frustrations of equity investors. Conclusions (1) US investors remain fundamentally positive on Japan, but confused by economic indicators and underperformance year-to-date. Despite this, 22% expect Japan to be the best-performing equity market in 2007. (2) Japan has likely exited "clunkritude" — structural underperformance. The reasons are: (a) increased ability to realize productivity gains, (b) benefits from growth in BRICs, and (c) existence of relatively attractive, efficient capital markets. Market implications (1) Foreign investors are likely to continue investing in Japan. Indeed, a significant shift into Japan could occur when confidence in a continued recovery rises. (2) Since foreign investors see higher oil and a stronger yen, they are likely to emphasize domestic names over exporters. Risks (1) Poor indicators could dampen enthusiasm for Japan, and make a revival that much harder. (2) Japan could be more exposed than some other countries to geopolitical risks, e.g., a confluence of higher oil prices and nuclear proliferation. Morgan Stanley’s annual investor conference at Lyford Cay took place last week, and again Japan played a prominent role in investors’ minds. Yes, investors are frustrated with Japan equity performance this year, but there remains a very strong flow of positive interest. Investors’ views on the world As usual, the conference began with a polling of investor views of the likely world in 2007. An overwhelming majority believed that equities would be the best-performing asset next year. By region, the big favorite was the US, with 50% of the votes. Japan and emerging markets tied for second at 22% each, and Europe got only 6%. After such a frustrating year in Japanese equities, the fact that 22% see Japan as the best performer next year surprised me. By sector, the investors’ favorites were tech and healthcare, both of which are well represented in Japan. There were broad distributions of views on global markets, but investors generally saw crude oil skewed toward higher prices, the yen skewed toward modest strengthening, and the US fed funds rate skewed toward cuts, despite a skew toward higher headline inflation in the US. The combination of a modest preference for Japan along with skews toward higher oil and a stronger yen imply a very clear investment strategy for American (and participants were mostly American) investors: Avoid exporters and overweight domestics. Will Japan escape "clunkritude" permanently? The conference session at which Japan was discussed specifically was titled BRICs versus the Clunkers. My spot on Japan was scheduled to go for 10 minutes, but in fact lasted for almost 30 minutes, due to the large number of questions. My main point was that Japan is an ex-Clunker, and has escaped "clunkritude" permanently, for three reasons: First, the potential for productivity gains in a broad swathe of industries remains huge. If large non-manufacturing firms used their assets as efficiently as large manufacturers, the return on assets of the former would rise from 3.9% to 6.0% Second, the very strong needs of China, India and other developing countries for capital deepening will create huge demands for machinery — one of Japan’s comparative advantages. For example, China’s per capita GDP at purchasing power parity is about US$5,500, and that of the US is about US$39,500. Even with a 20-year horizon for bringing Chinese per capita GDP up to the current US level, the relatively slow growth of labor force in China means that the bulk of the increase of supply will have to be achieved through capital deepening. Third, Japan has sophisticated capital markets, and has improved corporate governance tremendously, making Japan a very investable market. While there are serious issues in the regulation of capital and financial markets in Japan (as there are in the US), Japan has a firmly established rule of law, a very strong telecommunications base and well-known customs and institutions. Moreover, my view is that the population in Japan understands very well that maintaining their own standard of living depends vitally on raising productivity. Otherwise. PM Koizumi could not have remained in office for so long, and his successor, PM Abe, would be taking so strong a philosophical position on smashing vested interests. There was little objection to what I said, but there were some piquant questions. The most piquant was, " if things are so good, why has the Japanese market performed so [expletive deleted] poorly this year?" There are three reasons: One is that foreign investors in particular are over-concerned with economic indicators. One must be a connoisseur to understand the wrinkles, which often make the truth quite different from the headline. A perfect example came in the pre-dinner speech by an eminent historian, who was nearly panicked by the sharp decline in Japanese base money over the last few months, and worried that it might presage a global economic implosion. One investor — a Japan expert — saved the day by pointing out to the historian that Japanese base money has been distorted by quantitative easing, and thus the implication of the decline is far below the surface appearance. Second, economic fluctuations in Japan have moved from business cycle to business wiggle. Due to IT and much accelerated product cycles, even small increases in unwanted inventories are followed by quick production adjustments. This quick response results in a longer, smoother business atmosphere. If markets are still thinking cycle while the economy is actually behaving with a wiggle, then markets will over-react to data. Third, investors need proof that the Abe government will be as aggressive as the Koizumi government on reform. The new government has talked the talk, but it has yet to produce an event, such as PM Koizumi’s quashing of an appeal by the bureaucrats against a court victory by leprosy patients, that shows PM Abe has sharp teeth. The biggest of big pictures Although the eminent historian may have misinterpreted details about high-powered money in Japan, he had some spot-on observations about Japan’s position in the current global geopolitical situation. His main point was the disconnect between the front page of the newspapers, where all the news is bad, and the business page, where all the news is good. If the global geopolitical order is truly collapsing into protectionism, resource wars and terrorism, then stock markets should not be rising. The historian attributed the dissonance to the timing lags between globalization and the populism that its inequalities have generated around the globe. After all, he said, the spread of Marxism in the late 19th and early 20th centuries was a populist response to the inequalities created by the globalization of that era — in turn enabled by revolutionary technologies. Today, we have just as revolutionary technologies, an even larger wave of globalization and a similar rise of populism. Japan, the historian said, is the most exposed of the major countries to adverse effects from the tension between globalization and populism. Not that populism is particularly strong in Japan per se. But the effects of the tension are most likely to be seen in oil markets, nuclear proliferation and dependence for demand on developing economies. Should things in global economics go pear-shaped, Japan would be among the worst affected, due to its heavy dependence on imported oil, on demand in China and on others — whose interests may diverge from those of Japan — to provide a nuclear shield.
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Breathing a Sigh of Relief
November 14, 2006
By Takehiro Sato | Tokyo
What’s new: Headline real GDP growth was surprisingly ahead of both the market outlook and our more upbeat anticipation. Per today’s result and our present economic forecast, we tentatively retain our C2006 real GDP growth forecast at +2.8%. However, the GDP details included trouble spots, as below. Conclusions: Foreign demand temporarily strengthened as the driver of the economy in the quarter, bucking our original scenario, and the headline figure was certainly strong. In contrast, domestic demand components were weak, most noticeably in personal consumption, and a strong contribution from inventories seemingly pumped up the headline. In all, domestic demand excluding net exports was up 0.1% QoQ, while domestic final demand excluding inventories (and external demand) was down 0.2% QoQ. Accordingly, this set of GDP numbers again suggests that economic growth momentum continues to slow after peaking in October-December 2005. However, in October-December, we still expect personal consumption to pick up, and the economy to return to a more balanced growth track. Policy implications: Although the GDP headline outran the potential output growth rate, domestic final demand lagged, and with downward revisions to inventories possible in the second preliminary figures (due on December 8), today’s GDP data won’t help accelerate another rate hike into C2006. Our main scenario for a subsequent rate hike is after the December Tankan, specifically at the January 17-18 Policy Board meeting. Risks: Sluggish wages have maintained slack employee incomes, despite an increase in hiring. The labor distribution rate is showing no signs whatsoever of snapping out of its two-year funk. Foreign demand drives the Japanese economy in July-September, bucking our original scenario First preliminary headline real GDP growth was surprisingly ahead of both the market outlook and our more upbeat anticipation, but the details included trouble spots, as detailed below. Foreign demand temporarily strengthened as the driver of the economy in the quarter, bucking our original scenario. In contrast, domestic demand components were weak, most noticeably in personal consumption, and a strong contribution from inventories seemingly pumped up the headline. In all, domestic demand excluding net exports was up 0.1% QoQ, while domestic final demand excluding inventories (and external demand) was down 0.2% QoQ. Accordingly, this set of GDP numbers again suggests that economic growth momentum continues to slow after peaking in October-December of 2005. Some features of the economy are showing risks similar to the soft patch in the latter half of 2004. However, this seems unlikely, in our view, as (1) the labor market is tightening due to structural factors, and (2) the asset market and prices, both barometers of the economy, have improved remarkably since 2004. Given the economy’s greater resilience to reverse shocks, we think that there is negligible risk ahead of a major correction in the economy. Despite some lingering external concerns, we still expect the following to guide the economy in October-December back onto a more balanced growth track: (1) improved weather conditions; (2) an increase in bonuses; (3) growing grassroots sentiment; and (4) a US economic pick-up. Meanwhile, per today’s result and our economic forecast (as of September 11, 2006), we tentatively retain our C2006 real GDP growth forecast at +2.8%. We do intend to draw up our revised economic outlook as soon as possible within the week, in light of the GDP figures. Component breakdown The following four components accelerated or made positive contributions towards growth over April-June. (1) Net exports (+0.4ppt QoQ; +1.7ppt annualized): Real exports were +2.7% QoQ (+0.4ppt contribution) and real imports -0.1% (+0.0ppt contribution). Brisk exports, mainly in autos (despite the economic slowdown in the US), and lower imports on sluggish domestic demand resulted in a significant positive contribution. Our US economics team expects the US economy to right itself from October-December, and we expect net external demand to stay in gradual positive growth territory. (2) Inventory investment (+0.3ppt QoQ; +1.2ppt annualized): The major revisions in GDP-based inventory adjustments and irregular patterns of these revisions bring the accuracy of these data into question. In view of this, inventory may have been boosted ahead of the year-end sales season for IT-related products and the launch of new model game consoles. The second preliminary figures to be announced on December 8 may see a downward revision based on the MoF Corporate Statistics. (3) Residential investment (+0.1% QoQ; +0.5% annualized): Residential investment reflected the boisterous housing start trends. With rising prospects for higher interest rates and loosening supply-side factors on sales competition for home mortgages by banks, the basic trend remains strong, in our view. (4) Fixed capital investment (+2.9% QoQ; +12.0% annualized): Capex remained solid even after the surge of pent-up demand in the April-June quarter, and has shown double-digit growth. Going forward, we expect large-scale infrastructure-related demand in transportation/energy and non-manufacturing industries to underpin capex, and do not anticipate a major fall despite the relatively weak showing in Machinery Orders data recently. Our view is supported by the October BoJ Tankan, which emphasized the strong corporate appetite on capex. The following components were weak and pushed down domestic demand significantly (5) Personal consumption (-0.7% QoQ; -2.9% annualized): Personal consumption was bad, owing to poor weather and stagnant wages. Consumption in August-September picked up to an extent but was not enough to recover the loss in July. Wages are struggling despite an increase in hiring. Real employee incomes inched down 0.1% QoQ. The labor distribution rate was 51.5%, and has yet to snap out of a two-year funk, despite rapid growth in the corporate distribution rate. That said, the weather element should disappear in October-December, and consumption should be buoyed by increased wages from solid corporate profits. (6) Public investment (-6.7% QoQ; -24.2% annualized): Public investment was in major negative territory amid ongoing budget cutbacks. There have been reports in the media that the government plans to reduce public work-related spending by 3% in the F3/08 initial budget. Spending should tighten further ahead as the initial budget is often left unused, reflecting the severe financial conditions of local governments. GDP deflator The GDP deflator in July-September is entrenched in YoY decline, at -0.8%, but improved over the April-June quarter, at +0.4% QoQ. The past series of data has been retroactively revised back to 2005 in accordance with the CPI benchmark revisions. As a result, the July-September GDP deflator appears to have been forced down by 0.2ppt YoY, which is likely propping up real GDP growth. This is not boosting the nominal growth rate, however, and certainly does not portend positive implications. Viewing the breakdown, the import deflator continued to post strong growth (+11.7% YoY), aided by high landed crude oil prices. Meanwhile, the domestic demand deflator returned to positive growth (+0.1 YoY) in July-September, for the first time in eight-plus years since January-March 1998, despite a downward revision to the previous quarter into negative territory. This is encouraging news. Among the domestic demand deflators, the public and residential investment deflators continue along a growth path, while the capex deflator climbed up into slight positive growth. Looking ahead, we expect the GDP deflator in F3/08 to return to a positive level for the first time since 1997 (reversing the switch in positions of the real and nominal GDP), due to: (1) the expected decline in growth for the import deflator due to softer prices for landed crude oil; and (2) our outlook for sustained gradual improvement in the domestic demand deflator. Additionally, upside from the GDP deflator ahead could grow further from our original forecasts, based on recent crude oil price trends. Policy implications Although the GDP headline outran the potential output growth rate, domestic final demand declined. Thus, today’s GDP data won’t help accelerate the timing of another rate hike. An expected, a downward revision to inventories in the second preliminary data on December 8 also supports this view. Our main scenario for a subsequent rate hike is after the December BoJ Tankan, specifically at the January 17-18 Policy Board meeting. Even with soft economic data flow, we think the point that could force the BoJ to carry out an early rate hike would be a concern for major swings in the economy/prices ahead as ultra-low interest rates are long-maintained. At the same time, because of a recovery in asset prices, as well as the new Cabinet’s growth-oriented economic policies, we look for the consumption tax rate hike to be further out than the consensus outlook of F3/10. Another tailwind for the BoJ is the weakening of the yen on a real effective basis. Thus, we expect the BoJ to continue a measured pace of rate hikes, basically one every half-year, regardless of the policies taken by the US Fed. Market implications Despite strong July-September corporate earnings results, firms’ overly conservative outlooks provide the stock market with a dearth of upward catalysts. However, we think that the market will likely start picking up gradually toward year-end (C2006), as analysts are likely to revise up their forecasts. In the bond market, meanwhile, we expect the downturn in long-term yields to abate for some time. The BoJ is likely to ignore recent data and stick with its forward-leaning stance towards future rate hikes based on "second perspectives", which should hold the yield decline in the 1.6-1.7% range for now.
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