Friday Spotlight on Japan

October 30, 2008

The Bank of Japan’s semi-annual Outlook for Economic Activity and Prices heads a crowded events and data calendar, which will project Japan and the yen into tomorrow’s spotlight. Anticipation of that report and a simultaneous cut in BOJ rates sent the Nikkei up 10% today and extended the yen’s retreat from last Friday’s peak of 90.95 per dollar and Monday’s high of 113.64 per euro. The last Outlook published April 30th penciled in GDP and core CPI forecasts for fiscal 2009 of 1.7% and 1.0%, identified a downwardly skewed risk surrounding those estimates, and abandoned a rate hike bias.

Japan is now in a recession, which could rival or even surpass the intensity of downturns in North America and Euroland. The economy has been hit by a succession of three major shocks and did not receive macroeconomic support until it was too late. An ill-advised tightening of building codes pushed the construction industry into a deep downturn last year. Residential investment fell 21.7% in the year to 4Q07 and still showed a 15.7% drop in the year to 2Q08. The second shock, which BOJ officials cited as the main danger in their April Outlook, was the boom in commodity prices and ensuing squeeze on businesses and households. The final blow has been delivered by a rising yen and sinking share prices. These trends have been pared this week in response to the G7 protest against excessive yen strength and mounting speculation that the overnight rate target will be halved tomorrow. It will be the first cut since March 2001. Despite counter-trend moves this week, the yen currently shows a 33% jump against the euro since peaking in July and gains against the dollar of around 26% since June 2007 and nearly 14% so far this year. The Nikkei has lost 50.5% since peaking in July 2007 and is off 41% since the start of 2008.

Projected growth in FY09 will likely be cut by BOJ officials to about 0.5%. A case can be made that growth next calendar year an even possibly in the fiscal year that starts in April will have a negative sign. Data out this week have been weak. Industrial production posted a third consecutive quarterly drop in 3Q and a bigger one than in either the second or first quarters, plus preliminary indications suggest that output in October-November will be 1.3% or further below the 3Q level. Large-store retail sales slumped 3.3% in the year to September, the sharpest 12-month decline in 14 months, while overall retail sales dropped 0.5% between August and September. Business sentiment at small Japanese firms fell sharply to 37.6 in October after averaging 40.3 in 3Q and 42.0 in 2Q08. Along with the BOJ meeting and report, Japan on Friday will be reporting statistics covering consumer prices, the labor market, household spending, activity in manufacturing, housing starts and construction orders. These figures should reinforce the picture of a broader and deepening recession. On-year growth had already slowed from 3.2% in the first quarter of 1007 to 0.7% by 2Q08, when real GDP slumped 3.0% at a seasonally adjusted annualized pace. During the second quarter, consumer spending (-1.9% saar), residential investment (-13.3% saar), non-residential business spending (-1.9% saar), and exports (-9.7%) all fell significantly. The GDP deflator fell 1.5% in the year to 2Q08. Now that energy and food price pressures are receding and the yen is strengthening, non-food and energy consumer prices seem poised for a relapse into deflation. The so-called core-core CPI fell to a 12-month rate of zero in August and has hovered between +0.1% and -0.1% since last November. That was before downward pressures intensified.

Japan needs more than a 25-basis point cut in rates. In light of dim results from several fiscal packages last decade, I doubt the Y 5 trillion fiscal stimulus will turn the tide. The most urgent needs are sustained depreciation of the yen and recovery in share prices, plus healthier-than-expected demand from other Asian markets for Japanese exports. In fact, this week’s rally in the Nikkei and sell-off in the yen set up a classic buy-the-rumor-sell-the-fact situation when the Bank of Japan delivers a rate cut tomorrow. It would have worked better if officials had coordinated their rate cut with the Fed’s on Wednesday and used tomorrow’s press conference to announce a major shift in priorities with a commitment to do whatever is necessary to terminate the recession as quickly as possible. 

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