Takehiro Sato | Tokyo
Prices could contract again if the core of core does not rebound soon
What we outline here is a risk scenario, not our main one. Nevertheless, we do not think it is a low-probability scenario, considering that the latest reading on price growth is very low, at just 0.1% YoY. In light of oil price trends, the Japan-style core CPI could contract again YoY in 2007 H1, contrary to our constructive economic outlook.
We currently do not expect such a development for our main scenario; rather, we assume the core of core (excluding energy, broadly defined utility charges, and other special factors) will rebound solidly. In the six months through October, however, the core of core vacillated around -0.1% YoY.
Meanwhile, BoJ officials appear to be expecting the November nationwide CPI, to be announced on December 26, to show no negative contribution from declines in mobile phone rates, as in the past year, and they appear to have more or less given up on a rate hike in December and instead to be leaning toward a rate increase in January. The November nationwide core CPI, however, is likely to be up only 0.1% in light of the November decline in gasoline prices, the indications in the November Tokyo-area CPI of an impact from price declines for winter clothing owing to the warm winter, and the weakness in the core of core figure.
We doubt the core of core CPI will suddenly rebound in the next few months; if it is flat YoY, the Japan-style core CPI may contract starting around April-June, or even earlier because the contribution from oil prices may turn negative.
BoJ’s view on output gap based on revised GDP figures
The recent, substantial, retroactive GDP revisions confirm the weakness in the core of core CPI. For the F2006 national accounts, real GDP was revised downward by 0.9 ppt to 2.4%, which should have more than a negligible impact on estimates of the output gap since the economy’s potential growth rate is just shy of 2% at best. Based on the revised GDP data, the pace of the contraction in the output gap in F2006 declines by almost 1 ppt. If the improvement in the output gap is only modest, the spillover effect on prices would naturally be that much weaker.
BoJ officials, however, believe the output gap is not affected because the GDP revisions also lower the potential growth rate, or that the output gap has nothing to do with the GDP revisions because it is calculated from capacity utilization, rather than the divergence between actual and potential GDP. We doubt we are the only ones who sense sophistry in this argument. The output gap is traditionally calculated as the difference between actual and potential growth, the latter based on inputs of capital and labor using the historical averages for capacity utilization and labor participation rates. If actual GDP declines substantially, the potential growth rate also declines, but to an extent that is negligible. Rather, we think it would be prudent for policymakers to focus on the substantial slowdown in the pace of improvement in the output gap stemming from a decline in actual GDP. Under such conditions, market participants find it difficult to understand the BoJ’s concern more for the future upside risks to prices and asset prices than for the near-term downside risks to prices.
Worst-case scenario: Downturn in prices after another rate hike
Let us consider what might happen if the risk scenario does play out. Even with the slump in prices we mention above, much depends on whether the BoJ raises rates for a second time by January. We assume it does for our main scenario, but the likelihood has lessened somewhat, considering the weak extent of the positive spillover from the corporate sector to the household sector. The following scenario is thus a worst-case one. If the Japan-style core turns negative several months after the next rate hike, it would be easy to imagine the BoJ being in a politically difficult situation in terms of putting a crimp in the Cabinet/ruling coalition’s pro-growth policies. Governor Fukui would not likely have to resign, but the choice of his successor after his term ends in March 2008 could be affected to some extent. To be more specific, Deputy Governor Toshiro Muto, who is currently widely expected to be the next governor, may be less likely to be promoted and the government and the ruling coalition may instead look for a candidate outside the BoJ. Leading candidates in that case would be money-focused Heizo Takenaka, the former FSA minister, and Takatoshi Ito, a member of the Council on Economic and Fiscal Policy and an advocate of inflation targeting. If someone with a strong monetarist bent is named to be the next governor,
If the economy and stocks do well, a rate hike would be positive for the Administration
The above is essentially a mental exercise. After all, a prolonged, ultra-low rate environment would not be positive at all for the ruling coalition’s base of support. Rather, if the economy and stocks do well, a rate hike would be beneficial for the government and the ruling coalition. In fact, LDP officials, who had continued to try to check the BoJ’s moves, ended up embracing the BoJ’s moves in March to July, resulting in an end to ZIRP. Moreover, politicians and the media have generally reacted positively following increases in deposit yields.
A decline in the Japan-style core CPI would stem from a decline in oil prices and boost consumers’ real purchasing power, albeit not to the same extent as in the US. The US-style core CPI is likely to rebound moderately even if the Japan-style core CPI is weak. Also, the GDP deflator is likely to turn positive YoY around April-June, in a good contrast with the core CPI. Hence, assuming the government and the BoJ are at complete odds while prices are declining, such a scenario would likely be criticized for evidencing a lack of composure. To avert such a standoff, we think it would be natural for the BoJ to extend a certain amount of consideration and thereby protect its independence as well in an environment of price stability.
The market has priced in expectations of a rate hike roughly every six months, but we think the pace of rate hikes could be more moderate as a risk scenario, in which case medium-term yields would decline noticeably and the yen would continue to depreciate in real effective terms. Such a development would be generally positive because the stock market is concerned about a prompt rate hike while the economic data are weak. However, we find it paradoxical that stock investors, who had been so eagerly looking forward to a rise in rates, are now concerned about a rate hike.