Japan
Our Apologies for Erring
January 18, 2007

By Takehiro Sato | Japan

Let us apologize, first

To date, we had steadfastly maintained our view for an additional rate hike in January. The result, however, was a postponement. We would like to first apologize sincerely to all our readers for having misread the timing of the rate hike. The cause of our misreading was overconfidence in the capabilities of Governor Fukui, who has been pushing ahead vigorously with the normalization of monetary policy. It appears that the governor could not fend off the forcible pressure from the government and ruling party trying hard to prevent a rate hike. The pressure seems to have been much stronger than expected, as suggested by the leaked reports in major media outlets on Tuesday; we think the leak itself most likely came from the government. We would imagine that Deputy Governor Mutoh, who we think acted as a mediator between Mr. Fukui and the government, sensed the government’s intentions and persuaded the governor to postpone the rate hike. Unlike under the Koizumi administration, where the BoJ was able to terminate quantitative easing and the zero interest rate policy, the BoJ is stumbling to push through with normalization of policy under the Abe administration. A factor behind this could be the tough situation the present administration is facing regarding the upcoming Upper House elections in July. In our view, the additional rate hike in question was never a ‘must’, but our misreading of the forcefulness of political pressure played a part in our error. It is also probably true that the BoJ, though it shifted to a forward-looking monetary policy following the end of quantitative easing, struggled to persuade politicians with its contentions in the current environment where consumption and prices remain sluggish; the BoJ lacked the track record to push this through.

Both the BoJ and government are scarred

The BoJ undoubtedly is the biggest loser in the battle of information. Now that the rate hike is postponed despite repeated upbeat comments from the governor himself, a huge question mark about the bank’s independence remains. Hence, going forward, it is rather hard to base our outlook for monetary policy on economic fundamentals alone. The decision to postpone the rate hike may have been influenced by the BoJ’s considerations for the government/ruling party with the selection of two board members this April and the reshuffling of the governor and the two deputy governors in March 2008 in mind. Thus, there is now a greater need to monitor movements not only within the BoJ but also on the political and governmental fronts.

Another point is that this decision was not unanimous. The authority of the bank’s secretariat is in question after three dissenting votes were cast. Specifically, of the six votes supporting the status quo, three were from the officials including the governor and the two deputy governors. Excluding these, there were only three affirming votes, meaning that, in actuality, it was a close contest.

However, confidence in the government/ruling party won’t go unscathed either.  Interference in the central bank’s matters behind the scenes is commonplace, but this time it became public despite the BoJ being in a blackout period, which reveals a lack of information oversight on the government’s part as well as the BoJ.  NHK’s repeated coverage of today’s MPM proceedings in progress paints a similar problem.  

What to make of the future?

The BoJ has pushed back a rate hike to February or later to better assess trends in the key elements for a hike, spending and consumer prices. If spending in the upcoming October-December GDP data recovers sharply as we expect, this would justify a rate hike at the next MPM thereafter (February 20-21).  The government/ruling party is also able to save face by having a rate hike wait for the GDP data. Nevertheless, waiting for GDP data to revise policy would create a backward-looking framework based on specific or individual economic indicators, and likely hurt the BoJ ahead.  Even so, with three votes opposing the status quo as well, we support the February rate hike scenario. 

Conversely, a rate hike would also get progressively more difficult past February.  Consumer price trends are the dilemma.  The Japan-style core CPI (excluding fresh foods) could dip into negative YoY territory as early as the March Tokyo Metropolitan CPI to come out at the end of March, and the nationwide core could follow suit in the March data to be released at the end of April.  We believe that the BoJ would be letting a precious window of opportunity pass by if it bypasses a rate hike in February and March. 

Indeed, with negative price trends looming, forcing through a rate hike would certainly not be a forward-looking policy.   The bank’s relationship with the government/ruling party may also sour again from the spring.  However, lower prices due to softer crude oil do not signify renewed deflation, but rather bolster consumers’ spending power, in the bank’s logic.  Given the output gap improvement and gradual contraction in the decline in unit labor costs, the bank expects the baseline (core of the core; excluding special factors) to turn positive, and likely argue for a rate hike.

The problem is that even if the bank ploughs ahead with a February rate hike for instance, the outlook thereafter is quite uncertain as prices are expected to remain sluggish.  Our official core CPI outlook calls for the baseline to improve by +0.6ppt YoY through January-March 2008, but such high-paced gains are hard to imagine in light of recent weakness.  If the baseline fails to improve, the core CPI could revert to negative territory this spring, spurred by falling crude oil prices, and rather than anchor in positive range in F3/08, could even sink below the water level throughout the year.  If so, we would be forced to retreat from our present scenario of 0.25% rate hikes every six months.  The current hike delay by the BoJ also makes the above less a risk, and more a reality.  We plan to issue another report next week to amend our official outlook on the policy rate, based on the bank’s current policy decision. 

Market implications

Not only has the BoJ backed away from its normalization-focused monetary policies, but with the yen weakening on a real-effective basis as well, monetary accommodation seems to be gaining momentum.  We expect an increasingly reflationary macro policy environment to continue aiding the asset markets, most notably in real estate.  The bank’s move away from normalization also robs the bond market of its catalyst, higher interest rates.  Given the expected tightness in terms of the range of long-term rates now, if pressed to find upside factors ahead, we would suggest an excessive increase in asset prices and an overly softening yen. However, we would have to assume a rather extreme scenario for these factors to have an impact on long-term rates, and for now this seems unrealistic.  We think that a golden combination of a moderate increase in asset prices, stable long-term interest rates and a consistently weak yen on a real-effective basis can likely remain in place, even as the credibility of the bank wavers. 

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