United States
Will the Real Wage Measure Please Stand Up?
Jan 06, 2006

Richard Berner (New York)

Despite firming labor markets, wage gains have yet to quicken, giving comfort to policymakers and market participants that inflation will remain in check.  But two wage metrics are telling sharply divergent stories: Growth in wages and salaries measured by the Employment Cost Index (ECI) — generally considered to be the most accurate measure of labor costs — shows no sign of turning up.  Private industry wages have decelerated to just 2.2% in the year ended in September; that’s the smallest increase in the 25-year history of the data.  In contrast, average hourly earnings (AHE) are accelerating smartly; that monthly gauge rose by 3.2% in the year ended in November, a two-year high, and at a 3.7% annual rate in the past six months.  Which measure is sending the right signal, and what are the implications?

The truth about pay gains may lie in between these two gauges.  They differ in coverage, frequency, and sampling, and their recent divergence reflects some of those differences.  More fundamentally, in my view, rapid increases in benefits have held down gains in take-home pay in recent years, but that is starting to change.  As I see it, investors should not look to pay gains as leading inflation indicators; they tend to lag inflation and inflation expectations.  But rising unit labor costs likely will reinforce the incipient inflation increase, and firmer labor markets and elevated inflation expectations are likely to push both wage measures up at a faster rate in coming months.

Sadly, neither wage metric is ideal.   The ECI, according to the Bureau of Labor Statistics, is a quarterly, fixed-weighted measure of labor costs, so it is free from the influence of employment shifts among occupations and industries.   Wages in the ECI, which is designed to cover all workers, are defined as the hourly straight-time wage rate or a close proxy, and exclude overtime pay and nonproduction bonuses such as lump-sum payments provided in lieu of wage increases.  

The ECI thus theoretically is superior, but it has shortcomings: For private industry workers, BLS statisticians derive the ECI from a relatively small sample of about 9500 establishments.  While they rotate the sample completely every five years to capture changes in the economy, that procedure may nonetheless miss new industries.  What’s more, they derive the ECI’s fixed weights from the BLS’s comprehensive but dated 1990 Occupational Employment Statistics survey.  Many of today’s fastest-growing occupations did not exist in 1990.  In March, the BLS will unveil an overhauled ECI that may fix some of these inadequacies, but the transition to the new NAICS industrial classification system likely will invalidate historical comparisons.  The upshot, in my view, is that the ECI wage metric could recently understate pay gains because it may miss changes in the economy.

In contrast, Average Hourly Earnings (AHE) is a monthly gauge reflecting the actual earnings of workers, including premium pay.   It is simply the quotient of gross payrolls and total hours, so compositional shifts in employment often affect it.  It is thus not a true measure of wage rates, and it covers only production and nonsupervisory workers, although that subset amounts to 81% of private payrolls.  While the AHE is thereby clearly deficient, it has three offsetting advantages.  First, it is derived from the large and thus relatively reliable CES sample that covers one-third of all nonfarm workers at 400,000 establishments.  Second, it is timely, appearing with the monthly employment canvass.  Third, the lack of fixed weights that obscures true wage changes may ironically help it capture changes in the economy. 

Compositional shifts in employment in the wake of Hurricanes Katrina and Rita probably contributed to the recent acceleration in AHE.  The devastation of the Gulf Coast tourist industry cost 53,000 jobs in leisure and hospitality between August and November, and those jobs pay about half the norm, implying a shift to higher-paying jobs that boosted growth in the AHE.  But this distortion doesn’t change the basic message of acceleration.  As proof, and to control for such compositional shifts, we calculated a fixed-weight alternative, using 2002 employment shares.  The fixed-weight variant rose by 3% over the year ended in November, or 0.2% less than the published version, and 3.4% annualized over the past 6 months, or 0.3% less than the published data.  The upshot: While the published data may exaggerate the magnitude, the acceleration in pay measured by the AHE clearly sends a very different signal than the one in the ECI.

Many analysts attribute today’s tepid pay gains to globalization that has forced Corporate America to be stingy with raises.  I agree that globalization has been a secular disinflationary force, and that low inflation has held down nominal compensation growth, but I see today’s lukewarm pay through a different, domestic lens.  In my view, recent rapid increases in benefits, especially for healthcare, have been a more important factor holding down gains in take-home pay in recent years; employees view that tradeoff as acceptable, given that benefits are tax-free income.  While unpublished ECI data show that healthcare costs per hour have decelerated to 6.7% in the past year from double-digit gains in 2002 and 2003, some of that deceleration reflects the pickup in hours.  Increased flexibility in pay arrangements has also helped to hold down take-home pay gains, with more employees getting bonuses tied to company performance.

These developments are starting to change.   As I see it, pay gains tend to lag inflation, and firmer labor markets and elevated inflation expectations are likely to push both wage measures up at a faster rate in coming months.  There’s no magic threshold for the unemployment rate below which pay gains accelerate.  But with the jobless rate hovering around 5%, any improvement in job growth will likely tighten the screw.  Longer-term inflation expectations at 3.1% in late December have stayed slightly but firmly above their average of the past seven years.  And according to Morgan Stanley analyst Christine Arnold, employer-paid healthcare costs for large groups should decelerate to 6.9% in 2006 from 10.3% in 2005, making room for bigger gains in take-home pay.  Anecdotal and survey evidence also suggests that pay gains are improving or will pick up.  For example, the Fed’s Beige Book in November reported “modest overall upward pressures on wages with Minneapolis, Kansas City, and San Francisco Districts reporting moderate increases in wage pressures, …[and]..Boston, Richmond, Atlanta, and San Francisco [indicating] more substantial upward pressure on wages in one or more particular industries.”  

Now that monetary policy is no longer accommodative, inflation and wage developments will be critical issues for policy and market direction.  Fed officials in the minutes from their December 13 meeting “indicated that their concerns about near-term inflation pressures had eased somewhat over the intermeeting period.”   Accordingly, market participants increasingly believe that inflation will stay benign, and that the Fed may stop tightening after the January FOMC meeting.  In contrast, our call for higher yields hinges on our outlook for somewhat higher inflation and above-trend growth.  A pickup in pay gains will support both, simultaneously boosting unit labor costs and consumer wherewithal.  As always, risks to this call abound.  Wage gains could continue to be subdued for a while longer as benefit cost growth remains high and companies strive to maintain profitability.  But there are also risks that pay gains will now pick up faster than I reckon, having lagged inflation for an extended period.

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G10 Currencies
A Cyclical Dollar Downturn
Jan 06, 2006

Stephen L. Jen (London)

The ‘trendy’ phase is over

To me, 2005 was a year of normalisation in the currency markets.   The USD rallied last year primarily because it had been over-sold in 2004.  For 2006, I see a gentle turn in the dollar (strong dollar in 1Q, followed by weakness) in sync with a soft landing in the US housing market.  The dollar will be weaker by year-end relative to its current value, I believe, particularly against Asia. 

Three outstanding features of 2006

First, for the first time in three years the story for the dollar this year will likely be cyclical.   The only pent-up pressure I see is in the Chinese RMB.  At the same time, the G3 currencies will probably be driven by cyclical, not structural factors, and the US housing cycle is the dominant cyclical driver.  I expect the USD to depreciate with the softening US housing market, not because the overall US economy will slow sharply, but because investors are fixated on that sector and are likely to overreact.  Implicit in the view that the USD will not crash is my strong belief that global imbalances are a side-effect of other, bigger, issues in the world, most of which are related to globalisation.  Structural dollar bears are likely to be disappointed again this year for not getting full satisfaction in witnessing a USD crash or maxi-USD devaluation. 

The second key feature I see for this year will likely be a more meaningful appreciation of the Chinese RMB.   China’s C/A surpluses continue to grow, and I’m not convinced that sustained huge intervention will be politically acceptable anymore.  As a result, I think the Chinese RMB will likely be used as a ‘pressure valve’ this year.  As the CNY appreciates, it will push all the Asian currencies stronger against the dollar.  JPY will be the laggard in this bunch due to its very low yield. 

Third, in contrast to the previous four years, I believe the dollar’s movements are likely to be asynchronous against different currencies.   Specifically, I suspect EUR/USD has already been forming a base in the past weeks.  USD/JPY may reclaim 120 in the first weeks of the year, but should be pushed lower by the CNY by 2Q.  Commodity currencies, however, should depreciate against the dollar in 2H. 

Our central case assumptions and risks

First, we assume that global growth will remain robust, with some geographical and sectoral rotation, stronger growth in Euroland and Japan, slower in China, and unchanged in the US.   I should, however, stress that the currency team doesn’t mechanically feed its colleagues’ growth forecasts into its currency forecasts.  We also consider uncertainty, investor sentiment/biases, and other factors that may skew how currency investors respond to growth, such as investors’ fixation on the US housing market or the scepticism regarding the resilience of Euroland. 

Second, this year, we are likely to see the ECB, BOC, Riksbank, Norges Bank and SNB raise their policy rates, and the BOJ ending quantitative easing.   There is very little demand-driven inflation anywhere.  Monetary authorities are more concerned about the second-round effects from the latest oil shock (supply-driven inflation) and latent risks arising from nominal.  In contrast to other episodes of global monetary tightening, no central bank is at risk of falling ‘behind the curve’. 

Third, structurally negative investor sentiment toward the US economy and the US dollar is likely to persist.  Most investors still harbour great distrust toward the asset-based economic structure of the US and the dollar; they will be more eager to sell the USD than to buy it.  The market’s reaction may also be disproportionately more sensitive to housing market data than to other data (such as labour or capital flow numbers).  A good example is the market’s reactions to the Fed’s Statement and Minutes from the December FOMC meeting.  

Fourth, we might start to see an inflection point (not a turning point) in the US external imbalance.  Even though the US C/A deficit is likely to continue to grow − reaching 7.1% of GDP in 2006 – there are signs that we may be approaching an inflection point, particularly if Euroland and Japan are genuinely recovering.  Global imbalances are a direct result of globalisation and demography, not entirely the fault of the US consumer.  However, the ever-expanding C/A deficit will corrode investor confidence, and some signs of stabilisation will be positive for the dollar.  I believe we could see the first sign of this later in the year.

Bottom line

Currency markets will no longer exhibit powerful trends, such as those we have seen in the past three years.  I see a cyclical story for the dollar this year, in sync with the soft landing in the US housing market.  The dollar will likely be weaker by year-end, particularly against Asia.

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Euroland
Hike-As-You-Go at the ECB
Jan 06, 2006

Elga Bartsch (London)

In contrast to the Federal Reserve, which until now was on tightening autopilot, the ECB stresses that its December rate hike does not mark the beginning of a pre-programmed tightening cycle.   For the ECB it’s ‘hike-as-you-go’.  This does not mean, however, that the December rate hike was a one-off and that euro area interest rates will peak close to their current levels.  We expect the ECB to hike a quarter-point per quarter this year, with an aim to bring interest rates back to a more normal level.  But the ECB’s policy path will likely be more data-dependent than that of the Fed in the past, for two reasons.  First, the cyclical recovery is still more muted this side of the Atlantic.  Second, opinions are likely to be more diverse on the 18-member ECB Governing Council.  As ECB President Trichet stressed at the December press conference, the Bank will closely monitor all risks and will take the appropriate decisions based on incoming information.

The recent run of stronger-than-expected activity data suggests that our and market expectations for a 25bp ECB rate hike in March might turn out to be too timid.   In our view, the risks are starting to tilt towards a more aggressive move by the ECB in coming months.  Feeding the fresh survey data into our quantitative models suggests that euro area GDP growth is cruising at 0.5%Q in the final quarter of last year and 0.6%Q in the first quarter of this year.  If these estimates are confirmed by the actual data, euro-area GDP growth would clearly have remained above its meagre trend of 1.75%.  There are also signs that domestic demand is becoming more dynamic, with corporate spending leading the charge.  Our capex indicator is tracking a non-annualised 1.7%Q, nearly four times our official forecast.  Meanwhile, our consumer spending indicator, which, like the ECB’s, is based on retail sales, car registration and consumer confidence, still points to 0.2%Q for consumer spending.  A smart rise in consumer confidence in December to a three-year high suggests that households might start to join the spending bandwagon soon. 

Because the current rate cycle is mainly about bringing ultra-low interest rates back towards a more normal level, activity indicators will likely be the key determinant in ECB decision making, we think.   In addition, the risks associated with strong money and credit growth will be judged differently as the cyclical backdrop changes.  Meanwhile, coincident inflation should take more of a back seat in the ECB’s interest-rate discussions.  That said, the likely renewed rise in headline inflation in early 2006 is unlikely to sit comfortably with the hawks on the Council.  If the economic indicators keep coming in as strong as they have been over the last few months, the pundits will start to ponder whether the ECB could either hike interest rates earlier, i.e. at the February meeting, or more, i.e. 50bp at the March meeting.  For the time being, we would still stick to +25bp in March as our main case scenario.  But we believe that a 50bp rate hike in March has become more likely.  We would deem a bigger move the more likely of the two possible outside scenarios.  By March, there should be a sufficient number of new data points about the euro economy’s start into 2006.  The March meeting will also see the release of a fresh set of ECB staff projections, which would likely be water on the mills of those favouring higher interest rates. 

In order to pave the way for another refi rate hike in March, the ECB would need to signal that another move was on its way in one of the next two press conferences — unless, of course, the Bank plans to make preannouncements of policy shifts at public speaking engagements a regular fixture.  But as it seems to be safe to assume that the latter is not intended, we shall be all ears this coming Thursday.

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Euroland
Spreads to Widen, at Last
Jan 06, 2006

Vincenzo Guzzo (London)

What’s New: As the ECB starts a process of normalisation in rates that should eventually mop up the excess liquidity sloshing around the system, investors will likely become selective again and attach a more observable risk to each of the member states.

Conclusion: We think that rising short-term interest rates, together with divergences among real economies and budget policies, not to mention heavier supply calendars early in the year, will all lead to wider spreads among EMU government bond spreads in 1H06.

Implications: At the beginning, the rise in debt services costs should be modest.  However, if spreads stayed wider for long, the extra burden would affect a progressively larger share of the debt outstanding, resulting in more challenging debt management conditions for several issuers.

Risks: A stronger euro may reduce the scope for monetary tightening and thus for differentiation among sovereigns.  Yet an appreciated currency may lead to further divergence in competitiveness patterns and thus exacerbate differences in real economy performances.  Spreads would probably widen even in this case.

First signs of widening in 2005, more to come

The lack of differentiation among government bond yields in the euro area has long been a conundrum.   Only around the mid part of last year, repeated rating agency actions, political uncertainties following the rejection of the Constitutional Treaty, and the shelving of the Stability and Growth Pact in an environment of rising public deficits and debts produced some widening, but changes were small.  Yet we do think that rising short-term interest rates, together with divergences among real economies and budget policies, not to mention heavier supply of governments bonds early in the year, will all lead to wider spreads in 1H06.

Rising interest rates are by far the most important factor

At times of historically low rates, investors have ventured into riskier assets in an attempt to achieve higher returns.   In that environment, they could barely discriminate among high-yield, emerging market or other types of high-return assets, let alone among high-grade sovereigns.  However, as the ECB starts a process of normalisation in rates that should eventually mop up the excess liquidity sloshing around the system, we think investors will likely become more selective and attach a more observable risk to each of the member states.  Recently, the ECB reminded financial markets and governments that it would only accept bonds with at least a single A- rating as collateral in its refinancing operations.  While the statement raised a few eyebrows among market participants, a tightening cycle, albeit gradual, would certainly have a far more noticeable impact.

Country divergent performances matter …

In a monetary union, a country experiencing structurally low economic growth but paying an average cost of the debt broadly in line with its peers would soon find itself on an unsustainable debt trajectory.   It should be no surprise if the last period of significant spread widening between Italian BTPs and German Bunds occurred in 2Q05, precisely when data releases showed Italy to be falling into recession.  With Germany now regaining competitiveness and other countries lagging in the restructuring effort, new periods of real economy divergence are in our view a distinct possibility.

… as well different fiscal policy stances

Divergences are also likely to materialise, at least temporarily, through different fiscal policy stances.   Large countries are at various stages in their electoral cycles, with Germany now at the beginning of a new parliamentary term and Italy and France approaching important votes, in 2006 and 2007 respectively.  While prospects of a sizeable VAT hike should support the case for a tighter fiscal policy in Germany and lead to some reduction in the deficit to GDP ratio, greater uncertainty should surround the budget outlook for the other large countries in the run-up to elections, with possible further deterioration in the public accounts.

Supply calendar to play a role too

Finally, the seasonal pattern of government bond supply should also contribute to magnify differences in the first half of the year and even more so in the first quarter.   Our latest estimates suggest that gross issuance of government bonds for the four largest EMU countries should more than double in 1Q06 compared with 4Q05, moving to €160 billion from €77 billion.  The transition will be smoother for Germany, where supply should go up by just above 40%, according to the Federal Government issuance calendar and in line with our estimates, but more abrupt for France and Italy, where we see quarterly borrowing amounts respectively two and three times larger than those observed during the last three months of 2005.

More challenging debt management conditions

The conclusion is straightforward.   We think that all these factors will lead to higher differentiation in sovereign country risk within the monetary union.  By how much will spreads widen?  In early 2001, the spread between Italian BTPs and German Bunds moved all the way up to 45bp.  True, back then the overall level of interest rates was significantly higher, but the other arguments we discussed above should also play a meaningful role.  At the beginning, the rise in debt services costs should be modest.  Even for a high-debt country such as Italy, a 10bp spread widening across the maturity spectrum would only imply additional interest payments of less than 2bp, or just above €200 million within a year.  However, if yields stayed wider for long, the extra burden would affect a progressively larger share of the debt outstanding.  Moreover, the cost of wider spreads would compound with that of a higher outright level of rates, resulting in more challenging debt management conditions.

A stronger euro may exacerbate divergences

As the recovery in the euro area gains traction, a period of temporary currency strengthening may well follow.  In turn, a stronger euro may reduce the scope for monetary tightening and thus for differentiation among sovereigns.  This is not our underlying assumption, but even if this alternative scenario were to materialise, it would not necessarily be good news for some of the countries already struggling for market shares.  If anything, an appreciated currency may lead to further divergence in competitiveness patterns and thus exacerbate differences in real economy performances.  Spreads would probably widen even in this case.

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Asia/Pacific
Liquidity Receding
Jan 06, 2006

Andy Xie (Hong Kong)

Liquidity trend remains negative: Asian foreign exchange reserves continued to stagnate in the final months of 2005.   Even China’s forex reserves are rising less than its trade surplus.  The combination of a strong dollar and a rising Fed funds rate has caused the trend.

The end of the Fed rate hikes cannot reverse the trend: US money supply and the yen drive Asian forex reserves.  The Fed is unlikely to cut interest rates within 18 months, I believe, implying stagnant money supply in the US.  Japan is tightening fiscal policy and maintaining its loose monetary policy – a bad combination for the yen.

Volatility, not trend, should dominate 2006: The big central banks are unwilling to add more liquidity, but are reluctant to take back the surplus liquidity.   The liquidity stalemate suggests that volatility rather than trend will dominate financial markets in 2006.

It takes a shock to trigger the risk reduction trade: The declining risk premium has been self-fulfilling, with falling capital costs boosting economic activity, which in turn decreases financial distress.   When the risk premium stops falling, even if it remains low, it ceases to stimulate demand and financial distress returns.

Summary & conclusions

‘Talking it up’ has come back with a vengeance in the opening days of 2006.   The Fed minutes have acted as the trigger, indicating that an end to the rate hike cycle is in sight.  Despite the bullish tone in recent days, financial markets are likely to struggle this year, in my view.  The global liquidity trend is negative, as reflected in Asian foreign exchange reserves.  Historically, financial markets tend not to perform when Asian foreign exchange reserves are stagnant.

What has occurred in the past few days indicates that risk appetite remains high.   This reflects the fact that the level of liquidity is still very high, even though it is not rising like before.  Of course, high asset prices today already reflect high liquidity levels.  The major central banks seem reluctant to take back the surplus liquidity in the global financial system, even though they are unwilling to add more.  The stalemate suggests that volatility rather than trend will dominate asset markets in 2006.

Asian liquidity is receding

China’s foreign exchange reserves rose by less than its trade surplus in November 2005.   This has not occurred since sentiment towards China turned buoyant in 2002.  The forex reserves of Asia ex-China and Japan rose by 6% YoY in November 2005, versus an average growth rate of 23% in 2004, and did not rise at all MoM.

Asia’s forex reserves are the best indicators of the global liquidity situation, in my view.   Emerging markets traditionally perform poorly when Asia’s forex reserves are stagnant.  Because Asia is a dollar- and trade-driven region, its foreign exchange reserves tend to reflect the overall global liquidity environment. 

Historically, Asian forex reserves have reflected US money supply and yen strength.  When the dollar is weak against the yen and/or US money supply is rising rapidly, Asia’s forex reserves tend to rise rapidly and emerging markets do well.  The reverse is also true.  Furthermore, the former seems to lead the later.  If this relationship holds, Asian liquidity should tighten further in the coming months.

The euro area may be relevant for Asia this time.  Integration between Europe and China has increased dramatically.  The very loose monetary policy in the euro area could have an impact on Asia’s liquidity.  So far, the effect seems limited.  Asia’s liquidity still depends on US money supply and the dollar-yen trend.

The trend is hard to reverse

While financial markets are very excited about the prospect of US interest rates peaking, this does not indicate a reversal in the receding trend of global liquidity, as reflected in Asian foreign exchange reserves.  US short-term money supply and the dollar-yen drive Asia’s foreign exchange reserves.  This makes intuitive sense as the region is export-led.  US money supply reflects US demand strength.  Dollar-yen reflects the competitive position of the region.

For Asian forex reserves to accelerate again, we need the Fed to cut interest rates and/or the dollar to weaken substantially against the yen.   Neither is likely in 2006, in my view.  The US economy remains robust and the US inflation rate is at the top end of the Fed comfort zone.  I think it is unlikely that the Fed will cut in the next 18 months.

The outlook for the yen appears very weak in 2006.   Japan is tightening its fiscal policy to decrease its fiscal deficit and keeping its loose monetary policy.  This policy combination is best for Japan.  The Japanese government incurred huge debts to keep the economy afloat during deflation.  It seems reasonable for the government to be the first in queue to reap the benefits from the end of deflation.  However, the combination of loose monetary policy and tight fiscal policy is negative for the yen.

The high level of liquidity is sustaining risk appetite

What has happened in recent days suggests that risk appetite remains high.   This is because the level of liquidity is very high by historical standards.  The forex reserves of Asia ex-Japan have doubled since 2001, growing by three times as much as the region’s GDP.  The high ratio of money with zero maturity to GDP in the US also reflects this.

The major central banks are unwilling to add liquidity, but seem reluctant to take back the excessive liquidity supply of the past four years.   The stalemate suggests that volatility rather than trend should dominate financial markets in 2006.

What’s happening in the property market reflects the liquidity stalemate.   Trading volume is very low in erstwhile speculative markets such as New York, Hong Kong and Shanghai.  However, few speculators are going bust.  Financial markets continue to prop up the stock prices of property companies.  I believe that the availability of liquidity is giving speculators room to hold on.

It takes a shock to trigger the risk reduction trade

The major central banks are reluctant to take back surplus liquidity.   The peaking of inflationary pressure gives them a good excuse not to do so.  However, stagnant liquidity has increased the risk of a shock that could trigger the risk reduction trade.

The major central banks have been boosting demand by oversupplying liquidity, which has lowered risk premiums.  Declining risk premiums are self-fulfilling in the short term, as falling capital costs boost economic activity, which in turn decreases financial distress.  However, when the risk premium stops falling, even if it remains very low (as it is now), it ceases to stimulate demand and financial distress returns.  When a shock happens, investors discover that the euphoria over low risk premiums is not justified.  I believe this could trigger the risk reduction trade en masse.

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Japan
Joint Inflation Targeting in 2006
Jan 06, 2006

Robert Alan Feldman (Tokyo)

Conclusion: Japan will start joint inflation targeting in 2006

Japan will begin joint inflation targeting (JIT) in 2006.  Under JIT, there will be an accord between the government and the BoJ.  The inflation target will be set by a cross-agency body, not the BoJ alone.  Accountability will fall on all parties.  JIT is a Trojan horse for faster structural reform.

What’s New:   BoJ and government are already close to inflation targeting

Old and new statements on price stability from the BoJ put JIT a lot closer than investors realize.   The outlines of the accord are already emerging.

Market Implications:   good for equities, bonds

JIT will speed structural reform, raise real growth and contain fears of a new financial bubble.   High growth and stable price expectations should keep the equity market strong but reasonable, and should contain rises of bond yields.

Risks

Political and bureaucratic bickering could delay the accord.   Technical problems (e.g. how to measure prices accurately) could delay implementation.  Delays in US adoption of inflation targeting could also affect Japan.

A change of view

I have changed my view on the speed of introducing inflation targeting in Japan.   Last year, I thought that the debate would be long, complex, and painful.  However, after reviewing details of BoJ statements on price stability, academic literature on inflation targeting, technical issues such as price index accuracy, and political developments, I now believe that Japan will introduce inflation targeting within 2006. 

My colleague Takehiro Sato has already pointed out that BoJ is on the road to inflation targeting (See Road to Inflation Target, December 2, 2005).  Our views differ, however, in a key respect: Sato-san sees the BoJ is a target of political forces, whereas I see the BoJ as a voluntary — if skeptical — participant in a constructive, multilateral process.

What BoJ has said

In a 2004 paper, Prof. Takatoshi Ito and Prof. Frederick Mishkin attacked the BoJ.   Referring to the BoJ’s October 2000 paper On Price Stability, they said, “in the document, price stability was defined as a state that is neither deflation nor inflation.  Its apparent tautology did not help settle the problem.”  (Ito and Mishkin, Monetary Policy in Japan, Problems and Solutions, Columbia/NBER Conference, June 19-20, 2004).

What this BoJ document — endorsed by the Policy Board in October 2000 — actually said was this: “price stability, a situation neither inflationary nor deflationary, can be conceptually defined as an environment where economic agents including households and firms can make decisions regarding such economic activity as consumption and investment without being concerned about the fluctuation of the general price level” (emphasis added).   This definition is almost identical to that expressed by Alan Greenspan in his 1989 testimony to Congress, “Price levels sufficiently stable so that expectations of change do not become a key factor in economic decisions”.  Hence, the Ito-Mishkin criticism appears off the mark. 

The more important issue is whether price stability should be quantified and announced.   On this matter, the has BoJ said “no, for now”.  It gave several reasons for its reluctance to quantify.  (a) There are biases in price measurement.  Moreover, the biases are unstable, due to technological change and global events.  (b) Price instability can come from demand or supply.  Depending on the source of the instability, the response should differ.  (c) Measured inflation can lag price expectations, and thus give false signals.  (d) Without credible tools, declaring a target could lower policy credibility.

The key point is that none of these objections is set it stone.   Biases can be corrected.  Coordination with other agencies can determine what actions to take when instability comes from difference sources.  Central banks need not rely on an inflation target alone in setting policy.  Credibility can arise from effort as well as success, especially when coordination with other government agencies is good.  Reflecting these factors — and the need to avoid deflation — the Policy Board on October 13, 2000 said, “while paying due attention to changes in the economy, the Bank of Japan will nevertheless continue to explore whether price stability can be expressed by some numerical values”.  Thus, the BoJ clarified the problems that must be overcome before a quantitative inflation target would become advisable.

Nor did the BoJ stop there.   It even hinted at where the inflation target might lie.  Noting both the biases and the difficult problems of exiting deflation, On Price Stability said, “it is likely that an inflation rate corresponding to the conceptual definition of price stability would be translated into a slightly positive rate of measured inflation in the long run ...  Needless to say, a small but positive inflation rate is well within the scope of price stability”.

The CEFP should set the target and enforce the accord

The final step, determining a quantitative inflation target, runs into a few other important problems.   The two largest ones are democracy and coordination. 

The democracy problem is straightforward, and so is the solution.   Price movement affects crucial tradeoffs in the economy, e.g. borrowers versus lenders, workers versus management, inflation versus unemployment.  Even though the central bank was created, empowered and directed by the legislature, it does not necessarily follow that the central bank should be allowed to set the target inflation rate without consultation or accountability.  Thus, the setting of the numerical target should probably be done by a cross-agency body. 

Fortunately, Japan already has the perfect institution for this, the Council on Economic and Fiscal Policy (CEFP).  This body includes the PM, the Cabinet Secretary, four cabinet ministers in the key economic ministries, four representatives of the general public (currently two businessmen and two professors), and the central bank governor.  This body is already charged with determining the major direction of budget policies.  In my opinion, it is a logical extension of CEFP duties to charge it with determining an inflation target that is consistent with broad policy goals.

Coordination:   the accord has been outlined already

The coordination problem is harder.   Some people who should know better, such as Ito and Mishkin, still say that “inflation or deflation is, in the long run, ultimately a monetary phenomenon” (op cit., pp. 1).  The last 35 years of experience should have taught that supply-side factors matter, lags are long and variable, portfolio behavior matters, and globalization affects prices.  The Ito-Mishkin long run is very long indeed — perhaps the one in which we are all dead.  

More theoretically correct and more practical is the view taken by Prof. Robert Solow of MIT, in an interview with the Minneapolis Fed in 2002.   “I’m not terribly happy with the idea of counting off the instruments and associating each one with a target.  I think the better thing to do is to list the instruments and then decide in any instance how they can interact to meet as many of the targets as possible ...  The answer that you found among European central banks a few years ago ...  is that there really is only one problem [inflation], so there only needs to be one tool.  In the United States, we avoid that kind of senselessness, but it seems to me we approach another kind of senselessness.  Whatever the target is, we assign it to the Federal Reserve.”  

Japan today faces a serious fiscal problem, continued price declines and dire need for better resource allocation (in order to deal with ageing).  It seems the height of absurdity to claim that these problems are in separate silos, and thus that the BoJ alone can solve the deflation problem without considering the others.  It is equally absurd to think that the fiscal problem can be solved simply by a high rate of nominal GDP growth (even if the BoJ alone could achieve such a rate), or that resource allocation will improve merely by fast nominal growth.  There are multiple goals, multiple tools, and multiple interactions.  So Japan needs an accord among the monetary, fiscal, and structural authorities.

The accord is emerging

Already, the government has suggested such an accord.   In the April 2005 Japan’s 21st Century Vision, the Cabinet Office argued that inflation targeting should be part of a program of fiscal reform and resource reallocation.  It went further to suggest a 2% target for the CPI (close to targets of other industrial countries).  It even asserted that BoJ independence would be better guaranteed with an inflation target, because outside interference would become harder so long as the target was being pursued credibly.  (See Cabinet Office, “Nippon 21-Seiki Bijon, April 2005, pp. 75-6.)

Soon thereafter, the government’s annual Thick Bone Policy (“Keizai Zaisei Unei to Kozo Kaikaku ni Kan Suru Kihon Hoshin, 2005”, June 21, 2005), a document adopted by the Cabinet.  This Policy said that “the government, working hand in hand with the Bank of Japan, will further strengthen and expand policy efforts.  The government, in order to improve the output gap further, will further expand and accelerate structural reform.  With respect the to Bank of Japan, the government hopes for effective implementation of monetary policy.  We recognize that in general the real economy is on a gently recovery path, but also note that deflation is continuing.  In this context, we hope that BoJ policy is based on market movements and expectations and will be consistent with the government’s efforts to end deflation and with the economic outlook expressed in the period for strengthening key policy areas as discussed in the “Reform and Outlook:  2004 Revised Report” (Kaikaku to Tembo - 2004-nen Kaitei Ban).”   In this phrase, the government offered an accord: it will push structural reform, to raise and realize potential GDP and to allocate resources more effectively, in return for the BoJ designing monetary policy in concert with this effort.

This, by itself, is not a full accord, of course.   There is no specific model of the economy behind it, no list of goals, no list of tools, no list of responsibilities, no list of accountabilities, no tools for coordination, etc.  However, these factors are relatively easy to determine, once the agreement to cooperate has been made. 

Here again, the CEFP could play a very constructive role.   For example, correcting remaining problems in the CPI would be the role of Minister Takenaka, who has jurisdiction over the agency that complies these data.  Minister Yosano would work to ensure that the GDP data become more reflective of price trends.  The Cabinet Office and the Bank of Japan would work together on modeling the effects of different policy combinations.  The PM and the Cabinet Secretary would be responsible for delivering the next steps of structural reform from the Diet.  Gov.  Fukui would be responsible for convincing the BoJ Policy Board to ensure that monetary policy is set to achieve its tasks.

The politics of adopting JIT

The politics of the Diet currently favor an early adoption of JIT.   The importance of the government and the BoJ working together was highlighted by the very negative market reaction to apparent threats from the LDP toward the BoJ.  That said, the BoJ is keenly aware that the LDP has a super majority in the Diet, and can easily pass laws to clip the BoJ’s wings.  An LDP committee is currently working on a report on government/BoJ cooperation, with the initial report due in March.  Moreover, there are two appointments to the BoJ Policy Board in the next three months.  The Cabinet must nominate and the Diet approve these appointments.  The Diet can pack the Board with pro-inflation targeters, should the fight get nasty.  Both sides will lose from a spitting contest — as will the economy.

Fortunately, the debate is being carried out openly.   Thus, the BoJ, the government and the LDP will have to compete in the market of public opinion.  One idea, giving the BoJ responsibility for achieving a nominal GDP target, has already been floated by the LDP.  The idea is not likely to hold up under scrutiny.  First, a nominal GDP target alone would allow very high inflation but quite negative real growth.  The goal would be achieved, but the economy would be a mess.  Rather, as proposed by Prof. Hiroshi Yoshikawa, who is a member of the CEFP, a positive nominal GDP growth rate with real GDP growth of 2% and price growth of 1% would be the “ideal” target. 

Second, the nominal GDP target as proposed by the LDP is based on the so-called “Domar Theorem”.    This “theorem” states that public finances can be guaranteed to become stable only if the nominal growth of GDP exceeds the rate of interest on debt.  However, this “theorem” is long out of date.  It is a sufficient condition for budget balance, but not a necessary one.  The primary balance concept is more reliable.  Moreover, pursuing the “Domar Theorem” alone would ignore the rest of the economy.  Moreover, the “long run” could be very long indeed.  Finally, the politics of basing a monetary target on this approach are likely to backfire on the LDP, since fast nominal growth would likely allow the inefficiencies of spending policy — about which the electorate remain very angry — to continue.

Apart from the pros and cons of the “Domar Theorem,” the fact that the debate will occur in public is likely to assure markets that there is a fair hearing of the arguments.

Finally, the advent of Ben Bernanke, a committed inflation targeter, to the chairmanship of the Federal Reserve will likely put more pressure on central banks around the world to adopt inflation targeting. 

Conclusion

My conclusion is that the stars are aligned for an early adoption of JIT in Japan.   The BoJ need not end quantitative easing or end ZIRP before the framework is adopted.  Under JIT, there would be an accord between the government and the BoJ.  The inflation target will be set by a cross-agency body, such as the CEFP, not the BoJ alone, to be announced publicly.  Accountability for hitting the target will fall on all parties, with a list of actions that fiscal, monetary, and structural authorities must take.  In this context, JIT is a Trojan horse for faster structural reform.

Of course, there are risks in this outlook.  Political and bureaucratic bickering could delay the accord.  Technical problems (e.g. how to measure prices accurately) could delay implementation.  Delays in US adoption of inflation targeting could also affect Japan.  However, even if there are delays in implementation, the direction is clear, and markets are likely to react accordingly and positively.

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Israel
The Risk of Political Paralysis
Jan 06, 2006

Serhan Cevik (London)

Prime Minister Sharon’s deteriorating health increases political uncertainty.   Israel is not unaccustomed to unexpected events, but Prime Minister Ariel Sharon’s rapidly deteriorating health heightens political uncertainty in midst of an election cycle.  Mr. Sharon suffered a severe brain haemorrhage following a serious stroke last week and remains hospitalised in a critical condition.  According to medical experts, his initial conditions, requiring blood-thinning medicines, now make it extremely difficult to treat cerebral bleeding.  Therefore, even if he survives the latest episode, he may not have full neurological functions.  Needless to say, the incapacitation of Mr. Sharon, as he was striving to maintain economic stability and to reshape Israel’s strategy dealing with the Israeli-Palestinian conflict, introduces new risks and challenges.

Hoping to see political consolidation, markets now face the risk of political paralysis.   In a recent report, we argued that political reengineering initiated by leadership change in the Labour Party and, especially, by Mr. Sharon’s decision to form a new political enterprise called Kadima (meaning “Forward” in Hebrew) could lead to the consolidation of Israel’s fragmented political landscape (see The Attraction of Political Restructuring, November 24, 2005).  In our view, the benefit of strong leadership is not so much about maintaining prudent macroeconomic policies, but stems mainly from the possibility of building a momentum on the peace front.  Indeed, recent opinion polls (prior to the hospitalisation of Mr. Sharon) showed that almost two-thirds of Likud voters and, more interestingly, over 40% of Labour voters plan to support Kadima.  In other words, Mr. Sharon’s new party would easily have more than 40 seats in the 120-seat parliament.  Unfortunately, Kadima is still a one-man party lacking a proper organisational structure and, without Mr. Sharon’s charismatic appeal, is likely to experience a setback in the forthcoming elections.

Sympathy votes supporting Mr. Sharon’s vision would not be enough for electoral success.   Mr. Sharon’s strong, enigmatic leadership has been the main attraction for voters across the political spectrum.  Consequently, without Mr. Sharon’s control, Kadima would face the risk of a potentially destructive leadership quarrel and struggle to move beyond sympathy votes.  In our opinion, though the party has quickly become an umbrella organisation for centrist politicians and voters, maintaining the current momentum requires a strong leader who would appeal to a wide audience.  And this is not an easy task, even for a party with a deep pool of talent.  For example, Shimon Peres, the former Labour leader and a member of Kadima, has a proven leadership record but his background may not necessarily please the party’s conservative wing.

A ‘joint venture’ between centre-right parties is the best possible outcome.   Without Mr. Sharon, the Labour Party with a populist leader and the Likud Party led by Benjamin Netanyahu will likely dominate the political platform.  Since the inexperienced Labour leadership has adopted socialist rhetoric, market participants would probably prefer a Netanyahu government over a Labour-led coalition.  Even though the globalisation of economic policies (especially in the 1990s) has straightened the old distinctions between political parties, ideological and socio-economic realities may play a more significant role in the coming elections.  Since Israel’s strong economic recovery in the last three years has not lifted all the boats and led to socio-economic divergences (at least, in the short term), only a staunch leadership with a broader agenda can pay the political price of maintaining prudent macroeconomic policies.  As a result, while a ‘joint venture’ between centre-right groupings is the best possible outcome, the risk of political paralysis on key issues is not negligible.

The Israeli economy needs policy stability and the peace dividend.  In spite of increasing political risks, the economy should remain on its robust growth pace in the near future and the Bank of Israel has enough ammunition, thanks partly to an undervalued currency, to keep market expectations under control.  Moreover, even in the case of a Labour victory, we do not expect a major deviation from the principle of fiscal prudence.  As Israel’s own — painful —experience shows, fiscal policy is not the appropriate tool to address structural problems, especially in a small open economy (see Waking Up from a Keynesian Nightmare, October 1, 2002).  However, Israel’s performance in the longer term depends not just on the set of macroeconomic policies but, more importantly, on the peace process going beyond the disengagement from the Gaza Strip.  This is why the forthcoming elections represent a critical turning point in Israel’s political history.  All in all, even as we will focus on the threat of political fragmentation and its implications in the longer term, macroeconomic fundamentals are strong enough to support financial stability during an obviously precarious political transition, in our view.

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