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Monday, December 31, 2007

Japan, the 'Desireability' of Inflation and the Yen-USD Cross

by Edward Hugh: Barcelona

As Claus makes clear in his accompanying post, despite all the brouhaha of recent days, deflation is far from over in Japan. At the same time the Yen has once more begun to drift downwards against the dollar. In this note I will look at some of the implications of, and interconnections between, these two phenomena.

Whither the USD -Yen

Well it wasn't all that long ago that Claus was asking us when and whether the Japanese authorities would feel the need to intervene to stop the - at that point (9 Nov) - seemingly inexorable rise of the yen against the dollar. Obviously a few short weeks in currency markets are a very long time (which is why playing them has to be such a complicated business I feel), and as we can see from the chart below (kindly prepared by the people over at Daily Fx) since late November (ie just after Claus was having his think-out-loud) the market seems to have turned, and the yen has been in downward mode.

So what should we make of all this? Well first off I think I should make clear that when it comes to technical arguments, like the ones used by Daily Fx about A-B-C zigzag-wave evolution and all that, I am absolutely ignorant, this is not my area and all I can do is recommend you go over and read their take to decide for yourself. My view on this topic would be very much a case of the blind leading the half-sighted.

But... if I look at this chart as a macro-economist, then of course there are some things which seem to be blindingly obvious, and they fit in pretty well with the narrative we have been giving here at GEM as the year has progressed.

Basically we need to think about the relative interest rate policies over at the Fed and the BoJ. Essentially the yen's slide after February 2007 (following some initial upswing momentum in January) can be tied to the disappointment generated by the inability of the BoJ to carry out a vigorous "normalisation" process on interest rates. This inability, of course, was closely tied-in to the underlying Japanese macro-economic "fundamentals" ( a topic which Claus goes into in much more depth in his accompanying post).

Then as we reach July, growing bullishness from Fukui and the BoJ coupled with increasing stagnation in the US housing market produce a turnaround. The market seems to dither a bit around mid-October, as instability in the global scene has the effect that people really can't quite make up their minds whether the carry trade is going to unwind or not and whether Japan might not once more be turned into a safe haven in troubled times (hence all the coming and going, aka volatility), but the broad sweep of things continues until the market turns in late November, as people finally throw the towel in on the Japanese recovery, and talk moves away from when the BoJ will raise again towards how long it will be before we are back in ZIRP. In this sense I am inclined to back the conclusion that Daily FX draw from their technical analysis, but basing myself on the macro outlook.

The USDJPY has fallen nearly 200 pips since Thursday morning after testing a resisting trendline that dates to June. This price action has many believing that the downtrend that began at 124.13 is back underway. However, our interpretation of the price pattern suggests that a rally towards 115.00 is still very much a possibility.

As I say, I tend to agree, but my reasoning is other. Apart from the ongoing weakness that we are likely going to see in the yen, as the interest rate differential with some other Asian and Latin American economies make carry to somewhere or other still an interesting business, we have to think about the underlying fundamentals of the US economy and the evolution of future monetary policy in the US (of which more below, at the end of this post).

Should We Be "Happy" About The Return of Inflation To Japan?

Another of the "big-picture" details about the present Japan situation which is worth commenting on is the very mixed reception which the perceived return of inflation to Japan is receiving (although please note I am a long way from being convinced that things are as clear as many are suggesting on this front - and neither, as you will have seen in his post, is Claus - and it may well be that this months data is just another one of those continuous "false starts" we have learned to accustom ourselves to when it comes to Japan, especially when you take into account that the reading on "core-core" inflation - ie stripped of food and energy is still negative).

But in terms of whether inflation in Japan would be good news or not, I couldn't really help being struck by the lead paragraph in the Bloomberg coverage of the most recent Japan CPI data.

Japan's inflation rose at the fastest pace in more than nine years in November and industrial production and household spending declined, signaling rising oil costs may derail the economy's longest postwar expansion.
So what is going on here. Isn't the return of inflation to Japan just what everyone was hoping for? I guess the response of Swedish blogger Setfan Karlsson in his "Wasn't Rising Prices Supposed to be Good For Japan?" post will be a reaction which is typical of what many are feeling. Namely, "huh"!

So where exactly are we right now on the deftaltion front in Japan? Is the momentary return of a positive reading on the core index to be welcomed or not? Is inflation a good thing or a bad thing? Obviously the answer is the ambiguous one of "it depends", and it depends especially on what exactly it is you are looking at, but the difficulty we are seeing in defining a consensus interpretation of this phenomenon does give us a good illustration of what a hellishly complex business macroeconomics is. Not for the faint of heart this subject, I'm afraid.

Basically the problem is that economic systems are complex, and in them many variables are interconnnected in a way which may well produce important non-linearities in the way one parameter impacts on another. Inflation in Japan would be a good example. My feeling is that what you need in order to be a good macroeconomist is a feel for this complexity (and this is what sets the macro- off from the micro-economist, since the micro-economist is normally statisfied with some sort of partial analytic, you know, the good old ceteris paribus simulation, which may be very useful in terms of approaching certain very discrete and local phenomena, but turns out to be nearly useless when it come to real world, as it actually happens, macro). The macro-economist needs the ability to keep 3 or 4 (or more) variables in their head at the same time, and run sort of "what if" simulations mentally. Obviously it is hard to precisely assign an exact value to the number of parameters you need to keep spinning round simulataneously on any particular problem, or to give an explicit account of the system of virtual weights you implicitly assign to each of them, it is the scale of this that matters, and what counts if you want to do macro is the ability to carry out - on the fly - such large simultaneous mental simulations, since no computer model can possibly hope to handle the level of complexity involved, even if the parameters were well set up (ie included things like median age, fertility and life expectancy), which they aren't. The situation here is basically analagous to the semantic interpretation argument in the Artificial Intelligence debate, and this kind of problem is one of the reasons why I personally feel machine translation is - at the very best - a long way off in the future, and the same really goes for "true to life" economic models. Try doing a machine translation from German into English, and reading through what you get. The print-out you get from running some version or other of MultiMod has just about the same degree of satisfactoryness when it comes to taking key policy decisions in difficult circumstances. And this is why, of course, the simple application of a Taylor-rule type inflation target in a case like Japan simply isn't adequate (or for that matter over at the ECB right now, you just watch them squirm and execute all manner of verbal acrobatics on this if some of the key eurozone economies start to tank while inflation continues above their beloved 2%).

When we come to the inflation-in-Japan issue, the whole problem needs to be seen in the context of the undelying business cycle (and of course in the context of why there is deflation there in the first place, which is a story for another day). What Japan needs to try to achieve is a positive reading on inflation as the economy expands (although this, please note, would not solve the economic difficulties which arise from Japan's oustanding demographically-related growth problems, but it would make them a damn sight easier to handle). Japan needs this kind of inflation for basically two reasons:

1) Firstly, simply because it is easier to maintain stability on a bicycle which is moving forward than it is on one which is stationary or moving backwards, so 1 to 2 percent inflation under normal conditions is possibly ideal for an economy in general terms. I think even modern monetarists like Jean Claude Trichet accept this, and this is why the ECB, for example, has its target set on or around 2%, and not at zero.

2) This being said, the main reason you want some level of positive price movement in an economy is the technical one that without it you simply cannot run normal monetary policy. This is the argument - the technical liquidity trap one - that most people seem to have totally forgotten about recently (as I said, consensus discourse is normally only up to keeping one or two things in the head at a time). Back in February, when the BoJ finally decided to take the plunge and risk raising interest rates a further 0.25% to 0.5% I wrote a lengthy piece for Global Economy Matters - Japan in the Front View Mirror - where I basically argued that the whole "rate normalisation" policy being fomented by the G7 (a policy which had its origins in the central bankers and finance ministers meeting in Washinton in April 2006) and implemented by the BoJ was an error, and one which they might live to regret. Well, this is just where we are now, busy regretting all that "upswing exhuberance", and all the failure to really get down to the root of the problem. As I said at the time (and I think the whole article is still very much worth the read):

I cannot help having the unfortunate feeling that everyone is so busy eagerly looking forward (to the recovery, the end of the carry trade, or whatever) that they are making the glaring and rather irresponsible error of forgetting to check on what has been happening behind, and in the only all too recent past.......

The G7, as everyone by now probably knows, has just reasserted it's faith in the view that the Japanese economy is well on course to recovery. According to the official statement:

“Japan’s recovery is on track and is expected to continue. We are confident that the implications of these developments will be recognized by market participants”

Now this is a strange statement, since there are plenty of indications coming out of Japan that there are subtsantial doubts about this, and particular there are doubts about the resilience of domestic consumption in the current recovery, as Claus has already ably explained in two excellent posts (here and here). Since Claus will comment further on the details of the current decision, what I would like to do in this note is step back a bit, and reflect upon some aspects of the situation which should give us all cause for serious thought.

In particular there is the issue of deflation, and the danger that Japan may once
more fall back into the deflation trap. I say once more, since at the present
time I am already getting a strange feeling of deja vu, since few seem to
remember that the current approach was tried and found wanting once before, back
in 2000. Paul Krugman writing at the time had this to say:

So what if last Friday the Bank of Japan finally ended its "zero interest rate policy" (yes, ZIRP)? After all, it's only a quarter-point rise, in a faraway country that doesn't interest most Americans now that it no longer seems a dangerous competitor. And yet I would not be surprised if future economic historians look back at Friday's move as the beginning of the end for an era, and not just in Japan.

So what we have now is a rerun of what happened after the attempt to raise interest rates in Japan in 2000 signally failed (which was itself a rerun of earlier attempts back in the 1990s), since yet one more time the force that was mustered has been insufficient to overcome the resistance encountered. Would it be too much to ask that one of these days we got a reasoned and calm debate about why this might be, or is history here simply compelled to repeat and repeat itself? To repeat itself until of course Japan government debt (which is, naturally enough, now forecast to rise again next year on the back of renewed fiscal easing) reaches the point of no return moment, and then this story really willl come to an end, and more with a bang than a whimper I fear. But it would be very sad if things were to come to this pass without attempting to do something to avoid the eventuality first.

I strongly recommend reading Claus's No Signs of Inflation in Japan (1 Feb 2007), Japan's Economy Chasing Illusions? (19th January 2007) which give all the background on the whole debate, and will let you see had a glance who had been arguing sound-sense here, and who none-sense.

Now I did state that there are two potential grounds for feeling that a return of inflation in Japan - under the right business cycle conditions - would not be a bad thing, but I will rapidly correct myself, as there is also a third argument - one which brings us straight to the heart of the reason why what is happening in Japan is so important for everyone - since it refers to Japan's impact on the conduct of global monetary policy. Basically Japan having interest rates so near the floor creates uncomfortable problems for the entire world monetary system (the presence of the carry trade being only the most visible and high profile of these) and it was as a result of some of this discomfort - a world being steadily flooded with liquidity - that the Central Bankers and G7 Finance Ministers took their decision to try to encourage the "normalisation" of rates. The decision - which was based on the idea that the world was flooded with excess liquidity which badly needed "mopping up" - was initially implemented by the ECB, but the situation in Japan (and the role of carry) was never far from the forefront of people's minds, and the BoJ soon followed suit.

The rub is that this "normalisation" process, far from being based on a decoupling phenomenon in some of the world's largest economies - obviously I am talking explicitly about Germany and Japan here - has only served to underline the ongoing weaknesses which exist in them. So I would argue that the G7 participants really do now need to have some sort of a rethink about what it was exactly they were trying to achieve.

Basically the problem facing Japan is that the up-tick in inflation is taking place at precisely the same moment as there is a downtick in several other key economic indiactors. What this means basically is that Japan is getting squeezed on both fronts. As Bloomberg also note:

Core consumer prices rose faster than the 0.3 percent median estimate of 36 economists surveyed by Bloomberg News. Gasoline and kerosene contributed three-quarters of the gain, which was the quickest since March 1998, when an increase in the country's sales tax pushed the gauge to 1.8 percent.

So the last time inflation showed similar signs of life Japan was pushed straight off the cliff and into recession. History may well be about to repeat itself yet one more time here. But the real question is when will people actually start to learn some of the costly lessons experience is offering us?

So Where Are We Going in 2008?

As I said earlier the future of the Yen in part depends on the future of interest rate policy in the United States, so what are we able to discern in the tealeaves here? Well as I argue in this post (and back up with some additional demographic data in this one here) it is hard to envisage a dramatic easing on the part of the Federal reserve at this stage. The problems that the sub-prime bust are creating for the US economy have probably been rather overrated (interestingly sales of existing homes rose ever so slightly in November, which is just a small reminder that in a key area like housing demographics - rates of new household formation - do matter).

Sometimes I feel that there may even be a political interest in stressing that the global tightening in lending conditions is a spin off from a US problem (and not, say a Spanish or a UK one), since in countries with inherently fragile economies like Japan and Germany politicians and bankers may find it easier to explain to their citizens that what is happening is a result of a sub-prime bust elsewhere, rather than confronting head on where the real problem lies. This may be perceived as being more palatable for voters. Be that as it may, it seems to me that the US is more likely to be in for a "soft" than a "hard" landing, and this may well be reflected in monetary policy over at the Fed. What I mean by this is that the US slowdown may prove to be more protracted than many currently envisage - driven by liquidity constraints being placed by the banks on US internal borrowing, and by the continuing pressure on the US consumer wallet coming from higher oil and food prices (which are a knock on effect of the global recoupling process, and the increased purchasing power of people in the emerging economies, who are, let it be noted in passing, very numerous).

One point that I think is worth making is that in the course of the great fertility debate many US contributers tend to emphasise two factors which they feel help account for the comparatively high levels of fertility seen in the US of late: the spacious family environment and the ubiquitousness of the private car. Now, these two areas are precisely where this slowdown is going to bite hardest and longest in an era of structural changes in energy costs, since the US urban landscape may now be out of line with the change in relative prices that a declining dollar and rising global energy demand is going to produce. What I am getting at here is that if we ever do get a rising yuan, and the rupee continues its rise, then energy will get steadily cheaper in these countries in relative terms. I think this is not going to be a marginal, incidental point.

So the US slowdown may well be more protracted, but softer, than the markets are currently pricing in, while the Japanese slowdown may be more protracted and harder. Both these points argue in favour of continuing yen weakness vis-a-vis the US dollar in my opinion.

Finally I would add just at two caveats, and these concern the question of safe-havens and China. At this point in time we do not know what the global correction that we will in all probability see in 2008 is going to look like. We do know that some emerging economies will quite likely be badly affected (Eastern Europe, possibly Russia) while it seems likely that others (Argentina, Chile, Brazil, Turkey, Thailand and India) may well continue to power ahead. But we don't really know the details of how recoupling is going to work out in practice, and we don't know precisely which "safe havens" all those savings that continue to pile up in the pension and hedge funds will have recourse to. If Bretton Woods II is in the process of unwinding, and Bretton Woods III is in the process of being born, the we should expect to see changes here. As a knee jerk reaction, any initial instability in Asia is likely to send money across to Japan, but this may not be back to the "usual business", and particularly not if some large Asian economies - India?? - continue to grow at a hefty rate.

The other big unknown in 2008 is China. Most analysts are assuming a very gradual slowdown in China. Here I have my doubts. The inflation problem they have is a real one, and at this point in time it is hard to see how they can adequately address it. Certainly unchaining the yuan could just as easily lead to an acceleration of inflows and an increase in the overheating problem as to any more benign outcome, and I would treat New Zealand (and India for that matter) as the "Canary in the Coalmine" (or if you prefer "smoking gun") here. So I would just like to put up a question mark on this count, and I would do this especially in the context of the underlying and strong structural break in the Chinese population pyramid which has been produced by many years of the one child per family policy. Looking at those other canaries - Latvia and Estonia (and then Russia) push-comes-to-shove time does seem to arrive a lot earlier than we had all been anticipating. As I say, 2008 could well be the year that inflation gets a hold on China. Certainly the strong uptick in the latter months of 2007 is evident, as can be seen in the chart below.

Curiously this uptick coincides exactly with the peaking of the 15 to 19 age group, as you can see in the chart, and the decline in this age group from here moving forward is really quite dramatic, as you would expect from the drastic policy measure which was applied.

I have selected the 2022 horizon looking forward based on the fact that this is now known data. We can predict with a reasonable degree of accuracy just how many 15 year olds there will be in China in 2022, since they have now already been born. So we have a pretty good idea of China's new labour supply going forward. Obviously China can still get considerable growth by relocating the existing workforce across sectors to more productive ones. But the end of the labour intensive low economic value growth must now surely be in sight, and the big question is can China sustain inflation-free growth of the order of magnitude we have been seeing in recent years, bearing in mind that much of the recent growth in many of the higher growth developed economies - the US, the UK, Ireland, Spain - has been very labour intensive. My feeling is that it can't, this is why all those exhausted canaries swooning in Latvia have been so useful, and that we will see a slowdown in China which will not simply be cyclical, but rather structural. Possibly the moment of inflection (or tipping point) here will come around the time of the Olympic Games.

So, as I say the 15 to 19 age group has now peaked in China, and from here on in it is essentially downhill all the way, as far ahead as anyone can see. The truth is that no-one at this point in time knows what the consequences of this are going to be. But don't worry, since at least one thing is for sure: we are all just about to find out.