Turning Reflationary?
Japan might join the U.S.


David Malpass

Japan might pull out of deflation and join the U.S. in a multi-year reflation process. The key test will be whether the Ministry of Finance and Bank of Japan keep the yen from strengthening against the dollar as the U.S. reflates and Japan’s equities strengthen.

The yen has been relatively stable against the dollar in 2003, and the Ministry of Finance has been more adamant that it will prevent yen strength (though it’s still not clear whether the Bank of Japan will conduct unsterilized currency intervention). In contrast, the last time you could be optimistic about Japan’s outlook (from April to July 2002), Japan let the yen strengthen suddenly from 133 yen per dollar to 116, undermining the recovery.

But new Bank of Japan (BOJ) governor Fukui has shown more flexibility than his predecessor, taking small steps in the right direction by suggesting that the BOJ will buy a range of longer-term Japanese assets. The BOJ’s tolerance of rising yields and falling prices on Japanese government bonds is also encouraging.

To be sure, the BOJ will be Japan’s biggest financial loser in the event of a reflation, since it is a giant holder of Japanese government bonds. Former governor Hayami made clear that he didn’t want to see the BOJ lose money, the yen lose value, the Japanese consumer suffer negative real interest rates, or the consumer pay higher prices — in effect, he made it clear that he preferred deflation to the alternatives.

Fukui hasn’t expressed these views.

Japan’s monetary base is already huge ($10,000 per adult Japanese, quadruple the U.S.). If Japan’s risk-aversion subsides, perhaps due to U.S. leadership, Japan is liquid enough for growth to start. The yen price of gold is above its 10-year moving average. This indicates that Japan no longer has a scarcity of yen. Instead, the country’s deflation reflects a scarcity of risk-taking confidence, a factor that the U.S. reflation might turn around.

More, Japan’s consumer price inflation rate has turned less negative, though part of this is due to higher energy prices. In May 2003 (the latest reading), consumer prices were down 0.2 percent from a year earlier. In the spring of 2002, consumer prices were falling at a 1.5 percent annual rate.

Make no mistake about it, Japan is still a rich country. It has the world’s biggest net international investment position, the biggest international reserves, and one of the highest per capita incomes. Despite a large government debt, Japan’s debt-service ratio is low due to low interest rates. While Japan has depleted its value in recent years, it still has enough assets and educated population to create reasonably strong growth once deflation subsides.

For the record, Japan has had false reflation starts in the past. But the key difference this time around is that global monetary conditions now point to reflation. This is a sharp contrast with the global monetary conditions of the 1990s, when tight money outside Japan caused disinflation and deflation. In effect, Japan’s monetary stimulus is now swimming with the current, rather than against it. It should be strong enough to end Japan’s deflation as long as the BOJ doesn’t actively derail the upturn.

Japan has a choice. As Japan attracts capital, it can let prices rise or it can let the yen rise. In May and June of 2002, it let the yen rise, causing the deflation to continue. This time it seems more strongly resolved to preventing yen strength, offering the possibility of reflation.

In the past, Japan needed to change its monetary policy in order to break its deflation spiral. But now there is another possibility — U.S. reflation could be powerful enough to convince Japan’s private sector that deflation can end.



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