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Defeating Japanese Deflation

Prepared by: Lee Hudson Teslik
June 12, 2007

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After years of crippling deflation, the Japanese economy may finally have some spring in its step. The Bank of Japan, timidly but significantly, is raising interest rates. The bank has nudged (Marketwatch) the country’s benchmark rate twice since last summer, bringing it to 0.5 percent after having held it at zero for six straight years. At upcoming meetings June 14 and 15, all signs indicate the central bank will leave interest rates untouched (Reuters). But there is widespread speculation that the bank will hike rates a quarter point more by summer’s end. If rates continue to rise, the consequences could be far-reaching, both in Japan and globally.

First, there is the matter of deflation. For over ten years, starting in the 1990s, Japan’s economy was mired in a stifling deflationary cycle. As asset prices fell, the country’s money supply shrank and incentives to spend or invest dwindled. The Bank of Japan, accordingly, depressed interest rates to zero in an effort to boost borrowing. But low rates in turn weakened the yen and, the Economist argues, may have dampened spending by punishing savers rather than debtors. The daunting risk of a currency collapse (BusinessWeek) overwhelmed signs of positive growth, restraining the country’s economy while other East Asian countries enjoyed banner growth.

It’s unclear whether Japan has fully escaped deflation. Prices aren’t rising. The country’s Consumer Price Index (Japan Economy News), a measure that tracks the prices of a set of goods and services, fell in January, March, and April of 2007. Prices fell less sharply in April 2007 than they did the year before, however, prompting some analysts to forecast light at the end of the tunnel. These predictions were bolstered as economic data turned rosier. In early June, the Japanese government announced first quarter growth in 2007 was stronger (WSJ) than it had initially thought. Following this announcement, Japan’s Finance Minister Koji Omi asserted the country had exited the deflationary cycle (Bloomberg). The fact that the Bank of Japan has been raising rates, however cautiously, may well imply that central bankers share Omi’s optimism.

Assuming they are right, what will it mean? It is clear that the effect of rising rates would not be isolated within Japan. One possible outcome could be the dissolution of the “carry trade,” a practice used to exploit disparities in interest rates between Japan and other countries that has boosted the profits of many a hedge fund. Interest rate hikes and fears of a strengthening yen prompted concerns that the carry trade might unravel quickly and unpredictably, exacerbating a sell-off in global stock markets in late February and early March 2007. A more gradual unraveling, however, could have a positive effect, bringing equilibrium to currency markets that many analysts consider distorted by interest-rate disparities. A more confident Japanese economy could also help diversify global financial services. The Economist notes the recent health of Japanese equity markets is already prompting financial firms to drift back toward Tokyo, which over the past two decades has increasingly been marginalized as a financial center behind New York and London.

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