Different Signals From the Central Banks of Australia and Japan

August 19, 2008

Australia and Japan are both flirting with a recession, and each economy has excessive inflation that is likely to climb further before cresting.  But statements released overnight in these two economies had different tones.  The Reserve Bank of Australia’s minutes from this month’s earlier policy meeting accentuate the risks of a “deep slowdown” in growth, which must and will be mitigated by timely and perhaps aggressive rate cuts to neutralize an “unwarranted” tightening of monetary conditions evident in falling credit demand, asset prices, and economic growth.  Growth will be weak in both the second quarter and third quarters of this year, regardless of what the central bank does now.  While a stronger export/import price ratio will deliver a stimulus, officials view such differently now than they had a short while ago.  Instead of keeping policy in wait-and-see mode, this stimulus may not provide enough punch, and Australian officials will move forward with a rate cut on September 2nd even though inflation has not peaked.  The minutes in fact seem to be preparing markets not to be shocked if the size of the reduction is 50, not 25 basis points.  All the increases from a prior low of 4.25% to a current peak of 7.25% were done in increments of 25 bps.  The minutes did not abandon caution about a risk of intensifying wage pressures given above-target CPI inflation, but emphasis is now on the lack of evidence so far that such is happening.

The Bank of Japan Policy Board deliberated for an unusually long six hours and sixteen minutes when it met yesterday and today before keeping its interest rate at 0.5% and downgrading its economic assessment for a second consecutive time.  Officials all but concede that Japan has entered a recession.  All that was expected.  The surprise is that the medium-term and long-term elements of the forecast remain upbeat.  I had thought some time ago that monetary policy would ease if a recession occurred but not if growth merely slowed. With today’s minutes and action, officials lifted the standard for what could prompt the bank to cut rates.  The economy must “worsen sharply,” and Governor Shirakawa, a dove compared to his predecessor, called the chance of that happening “slim.”  The Policy Board’s decisions were unanimous.

The difference between the Australian and Japanese policy circumstances boils down to a single factor — the level of central bank rates.  Australia’s is at 7.25%, while Japan’s is just 0.5%.  We saw at the turn of the century how much inertia Bank of Japan officials had against ultra-loose monetary policy.  Rates had fallen to 0.5% as far back as September 1995, but it took a worsening deflation through several years to elicit a decline to zero percent and a shift to targeting the quantity of money reserves rather than an overnight money rate.  Australia’s central bank rate is above its rate of inflation, and Japan’s central bank lies below headline and core inflation.  The different signals from the two central banks today could further promote a decline of the Australian dollar against the yen.  In carry trading, investors used to borrow yen at very low rates and invest in Australia’s higher-yielding assets.  The risk to a carry trade stems from the possibility that the funding currency will strength.  That possibility is now stronger.  Today’s moves will further deter any temptation to engage in carry trading.

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