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Monday March 13, 2006 - 11:47:30 GMT
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Global financial markets not at risk as Japan’s monetary policy returns to normal

Economics Weekly: Global financial markets not at risk as Japan’s monetary policy returns to normal

Japanese recovery leads to policy change
Recovery in Japanese economic growth means an end to the ultra loose monetary policy that has been in place since 2001. Many worry that this will cause financial market dislocation and lead to added volatility, putting at risk those who had borrowed with cheap Japanese money to lend at higher interest rates in other currencies - the 'carry trade'. Our view is that Japan's actions could add to volatility in the short term (though there are few signs of that at present, see chart a) but we believe that the benefits for the world economy of a strong Japanese economy outweigh the negatives. We explore some of the issues in this week’s economic brief.

What did the BOJ announce?
By a vote of 7:1 with one member absent the Bank of Japan decided to end the support of zero interest rates by quantitative easing. It is estimated that the central bank provides outstanding reserves of some Y35,000bn to commercial banks well above the Y6,000bn thought necessary to keep short term interest rates at zero, thus offering them plenty of money to lend to potential borrowers. The central bank also announced that inflation of 0-2% a year was desirable, effectively announcing the inflation rate of 1% as being the central target. To some observers, however, the problem with this is that, given the difficulties of measuring inflation accurately, 1% might mean in reality that price inflation is zero. And this is not really a good position for the Japanese economy to be in since price deflation pushes up the burden of debt while price inflation helps to erode it.

The bank of Japan also shifted its monetary policy target back to the unsecured overnight call loan rate. But the aim is not for it to rise but to stay at zero. And quantitative easing is scheduled to take roughly three months to remove, with the bulk of this to be done at the end of the three month period. The central bank has said that it will be careful about removing the quantitative monetary overhang and any demand for funds will be met, irrespective of the removal of excess reserves. Moreover, it will continue to purchase some one-third or Y1.2bn of government debt outright at the regular auctions, so acting to shore up bond market prices. This helps to alleviate one fear: that as excess money dries up, commercial banks will funnel less into the bond markets and so cause yields to rise and choke off the economic recovery.

Moreover, even if there is some small rise in interest rates, say of 0.25% by the end of 2006, the yen will remain by far the cheapest currency in which to borrow. Credit conditions for those with outstanding commitments may be tighter but they are hardly likely to make the difference between profit and loss for the vast majority, which would be of concern to the central bank.

Financial market reaction to BOJ move was positive
Last week, the Bank of Japan announced that it was ending the policy of quantitative easing. Far from falling, the Japanese equity market rose on the announcement that quantitative easing was to end, see chart a. This is because a return to price inflation will help to grow company profits and reflects a heightened belief that economic growth will remain sustainable, and so outweighs the negative implication of a rise in the cost of capital. Also, the rally was due possibly to relief that the announcement was finally made, as the move was signalled well in advance and delay would have signalled high level policy uncertainty, which is not good for the investment climate. Japan’s bond yields started the week at 1.60 and ended at 1.66, up just 6 basis points and hardy a signal of bond market concern about higher official interest rates. This is probably based on the view that short-term interest rates are not likely to change in the near term (a rise of roughly 0.25% every six months is expected by the markets), and then only gradually with clear signals of the timing from the Bank of Japan.

Why the Bank of Japan felt it had to move to normality
The reason why the Bank of Japan felt that it had to normalise policy is shown in the charts for economic growth and inflation. The latter are both clearly up strongly, see chart b on page 1. Economic recovery is underway in Japan, the most sustained in 15 years. With annualised growth of 5.5% in Q4 2005 and price inflation of 0.5% in January, excluding food, the Bank of Japan felt that growth and inflation warranted action. Consumer spending is also beginning to recover, so the Bank of Japan's action should be seen as a sign that economic growth is judged to be self sustaining. The worry is that, once again, it has been based on exports to the US and China. However, chart c shows that domestic demand, in the form of investment and consumer spending, is driving growth as well, so this is likely to make the recovery much more durable. Moreover, deflation has barely ended and monetary policy though loose is not excessive if one looks at weak annual growth of only 1.7% in money supply (M2+CDs). (Compare this to the UK where broad
money growth is rising nearer to 12% a year). But this is why the bank of Japan has said that it will proceed only very slowly. On balance, it seems the right action to take, sending a sign that after 15 years of deflation, economic conditions are finally returning to normal in Japan. If correct, this can only be good news for the global economy. Moreover, it can only be a matter of time before the yen appreciates, supported by stronger economic growth, a current account surplus and interest rate differentials moving in its favour.

Trevor Williams, Chief Economist
[email protected]
Lloyds TSB Bank,
Financial Markets
Faryners House,
25 Monument,
London EC3R 8BQ
0207 283 - 1000

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